Sunday, 19 January 2014

The UK has hit its inflation target, but how are other countries doing?

by Viva Avasthi

Here's some good news for us here in Britain: the UK's inflation rate (as measured by the Consumer Price Index, the CPI) fell from 2.1% in November to 2.0% as announced earlier this week. It's the first time in four years that the target has been met. Use the graph below to see how inflation levels have changed over the years.

You might be wondering why this is good news - after all, is it not just another statistic? The answer which most economists would give at this point is, "absolutely not". This figure of 2.0% is significant because it is the medium-term inflation target set by the Bank of England (the UK's central bank). The BBC has written a clear and simple article perfect for newcomers to the subject on what achieving this target means for the British economy and the general public.  The Telegraph has written a more detailed article on the matter, which includes a variety of interesting opinions. However, I'd like to focus a little on why the target was set as 2.0% in the first place. I'll then go on to look at how successful other countries have been with their inflation targets recently.

Why does the Bank of England have a target of 2.0%?

The target isn't 0% for a variety of reasons:  
1. Having an inflation target >0% allows real interest rates to be negative, which can be a useful policy option when demand is weak, say during a recession.
'Real' interest rates are equal to the interest (nominal) rate minus the inflation rate (the actual rate of interest paid in money terms is referred to as the 'nominal' interest rate). When real interest rates are negative, people are better off spending their money rather than saving it, as any cash they deposit in their bank account will be worth less in a month's time than it is now. For this reason, negative real interest rates are a viable policy option to stimulate demand in an economy during a recession, when demand tends to be very weak as people want to save as much money as they can.
2. In reality, the rate of inflation actually tends to be a little smaller than the value generated by the CPI and other indexes for a variety of reasons.
For one thing, measures of inflation are only ever approximations because they take a sample of prices and don't include every single price for every single good into account. Another reason for indexes overestimating inflation levels is that improvements in the quality of goods (resulting in consumers getting more for their money) are not always properly incorporated into indexes due to the difficulty of doing so. Due to these factors, the inflation target must be greater than 0% to actually be targeting rising prices.
There's an explanation for the target not being greater than 2%, too:  
 Generally speaking, the higher the level of inflation, the more difficult it tends to be to control. (If you have the time and the inclination, you might be interested in reading bits of this report from 2007 which discusses whether high inflation is inherently unstable.)

However, even if we imagine a situation where high inflation might not be unstable, we would still have the issue of money declining by a rate of 10% (or whatever the high rate of inflation) every year, quickly rendering it rather useless as a standard measure of value for goods and services. The value of everything would have to be adjusted by that large amount incessantly.

Let's turn away from the UK and its inflation target now...

How far from their targets are the inflation rates of other countries?

I thought it would be interesting to compare how close to their targets some key countries are. Every country has its own inflation target as each economy has its own subtleties and requirements. The table I've compiled shows that not one of the countries I've looked at has hit their target, so in this at, least, Britain comes first (for now!). The trend appears to be that the developed economies are below their targets and the developing economies are above them.

This article's already taken longer than expected, so rather than commenting on the reasons behind why the countries below have the targets and the inflation rates shown below, I have provided links for you readers to be able to look into whichever countries' statistics most interest you.

CPI Inflation Target (%)
December 2013
CPI Inflation Rate (%)
(below, but close to)
(between 1 – 3% with 2% as the optimum)
Within band
From top of band
No explicit target
No explicit target
November data
Within band


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