Evolution of Inflation in the United Kingdom - Literature review Example

UK INFLATION FORECAST REPORT Introduction This is a forecast report that reports the analysis done on the United Kingdom Economy for a period ranging from 1992 to 2012. The report will use the data contained in the Econometric Views workfile (EViews) for the U.K economy for that period. The report also includes explaining the various variables contained in the date, for instance the history of inflation in the UK. Other variables to be studied include the unemployment rate, the real gross domestic product (GDP), the central bank interest rate (IR), and the money supply (M4).all this data is contained in the Econometric Views, which will be used in statistically forecasting the inflation using both the structural and non-structural models. The report will also be inclusive of the discussions and interpretation of the data generated by the Econometric Views software. The last part of the report will include the conclusion made on the findings and the results. Background of the Study The Bank of England is allocated with the responsibility of ensuring that the money stability in the economy of the United Kingdom is stable. The term money stability here is used to refer to stability in the prices. Stable prices reflect an increased value in the currency of the countries. The banks main objective is to meet the target that is set by the government. The government sets the inflation rate target that the bank seeks to maintain. This maintenance of the set target is achieved through the incorporation of the monetary policy committee. The idea at the back f the mind of the committee is that a rise in the inflation rate reflects a drop in the value of the currency. The monetary policy should hence be formulated in a way that it will achieve the objective of maintaining the prices. The money supply in the UK is controlled through limiting the rate at which money is being lent. This is done through controlling the bank rate. The bank also controls the rate of inflation through forecasting the future rates. The report is based on the forecasting techniques while taking into consideration other variables that influence the inflation rates. Literature Review Evolution of Inflation in the United Kingdom Inflation in the United Kingdom can be traced back in the 18th century where in 1750 the inflation rate was reported to be 0.00 percent ( Pettinger, 2011). The figures have however changed until recently where the inflation rate has been reported as 2.8 percent on February 2013 (Rogers & Sedhi 2013). This is per the report that has been published by the Office for National Statistics (ONS). This is a constant figure for the last four months as reported by the same department. It is reported that the living standards of the people of the United Kingdom have been falling for the past 12 months consistently. This has also been marked by a rise in the inflation rate way above the standard pay (Pettinger, 2011). The commonest method that is used while analyzing the rate of inflation is the use of the consumer price index (CPI). It is considered significant since it is used to rate the wages and benefits and the pensions upwardly. The consumer price index of the United Kingdom stood at 5.2 percent in September 2011.Another measure that is used is the retail price index (RPI). The difference between the two is that the RPI includes housing costs among the other entire item included in the CPI ( Pettinger, 2011). Table 1: Annual Historical Inflation Rates Data for the UK for the Years 1992To 2012 years Annual inflation rates 1992 4.3 1993 2.5 1994 2 1995 2.7 1996 2.5 1997 1.8 1998 1.6 1999 1.3 2000 0.8 2001 1.2 2002 1.3 2003 1.4 2004 1.3 2005 2 2006 2.3 2007 2.3 2008 3.6 2009 2.2 2010 3.3 2011 4.5 2012 2.8 The table 1 above contains a list of the annual inflation rates data for the United Kingdom from the year 1989 to the year 2012. The percentages are determined through comparison of the consumer price index growth rate from one period to the other. The inflation rates for the year 2013 are available for the months of January and February that is 2.7 and 2.8 respectively although some authors argue the rate is constant for the last four months. Graph 1.1: A Graph on the Historical Inflation Rate Data for the UK for the years 1992 to 2012 The data on the above graph was retrieved from the Table 1.the reason for this graph is to show the trend or movement of the inflation rates over the periods stipulated. The figure shows a rise in the inflation rate from the years 1989 to 1991 from 5.2 to 7.5 percent. Then a decline is observed from 4.3 to 0.8 percent in the year 2000.The figures then rose again consistently to 3.6 percent in 2008 and the trend then has changed inconsistently until 2013 where the figure now is 2.8 percent ( Pettinger, 2011). Interest Rates In the United Kingdom, the Bank of England has the mandate of setting up the monetary policy. The trend of the interest rates is normally analyzed in comparison with the inflation rate.fpr instance the current target set for the rate of inflation is 2 percent, plus or minus 1.if the rate rises above the set target, the bank of England is expected to increase the base rates to aid in reducing the inflationary pressures ( Pettinger, 2011). Graph 1.2: A Graph on the Historical Bank Rate Data for the UK for the years 1992- 2012 The graph above is a reflection of the movement or the trend of the bank rate in the UK from the yeas 2003 to 2012. The trend of the rates is inconsistent from 4 percent in 2003 to 2008 where the rate fell from 5 percent to 0.5 percent in 2009. The Bank of England cut the base rates to 0.5% from 2009 henceforth to accommodate the extent of the recession ( Pettinger, 2011). Gross Domestic Product (GDP) The GDP measures the rate of growth of the economy. The economic growth of the UK is marked between the years 1980 and 1988 before a decline to 1991 then a rise again. Growth of 5percent was recorded. When compared to the inflation rate, the growth stimulated a 10 percent increase in the inflation rate the following year until 1990 ( Pettinger, 2011).The trend from 1992 to 2008 where there was a slight decline. Graph 1.3: A Graph on the GDP for the UK for the years 1992- 2012 M4 Money Supply This is a measure of the circulation of the notes and coins and other bank deposits in an economy. The M4 lending rate is inconsistent through out the years. It reached a 23 percent mark in the year 2008 but declined in the year 2009. The rate has remained below 5 percent from the year 1010 until end of 2012. The falling and rising of this rate explains the changes in the inflation levels (Pettinger, 2011). Graph 1.4: A Graph on the money supply (M4) for the UK for the years 1992- 2012 Unemployment Rate The unemployment rate has been on the rise from the years 2005 henceforth. The 4.8 percent mark in 2005 has risen to slightly above 8.0 percent in 2012. When compared to the inflation rate, the unemployment rate increased with the increase in the inflation rate with the highest rate being in the Year 2011 When the Inflation Rate Was It Its Peak (Pettinger, 2011). Graph 1.5: A Graph on the unemployment rate for the UK for the years 1992- 2012 According to the graph1.5 above, the unemployment rate from the year 1992 has been declining rapidly until 2000 where the decline is steady. Inflation Rate Forecasting Unit Roots Test Given the data above, a unit root test was conducted by the use of the Augmented Dickey Fuller. The findings reveal that the series were not stationary. The sample of seven variables was used. These variables include the inflation rate for the period between 2008 and 2012, the unemployment rate of the same period, the gross domestic period of the same period, the interest rate, the share index from the companies listed in the London Stock Exchange (LSE), the Money supply (M4) and the exchange rate (Pettinger 2011).The exchange rate comprised of the sterling pounds per the US dollars. The Augmented Dickey Fuller unit root tests are carried out based on three regression forma that are differentiated by a constant. This case has a constant but has a trend, therefore the regression form employed was: The decision making point is based on the value of t given the critical values. If t is greater than the ADF critical values, the implication is that a unit root exists and vice versa. The exchange rate was assumed to be constant all through (Ruppert 2011). The computed ADF test-statistics as depicted in the attached EViews workfile is greater than the critical values. Due to this, the conclusion is that the inflation series has a unit root problem and is therefore not stationary. A DFT static of -1.94091 was yielded. The estimated critical value was -0.35137. The implication is that the series is a stationary series. Partial Auto-Correlation Function (PACF) of Inflation and Forecasting The partial autocorrelation function (PACF) identifies the order in which the AR process exist. It is also used to determine whether to choose the AR process or the MA process. The basis on which this decision is carried out is comparing the process in which the partial autocorrelation function approaches the zero mark in a slow pace or without falling rapidly. If the YT exists to be an AR (p) process, the implication is that the AR process can fit the Inflation time series if the sample used in the partial autocorrelation function (PACF) is not zero until it reaches the p. From the data above therefore, the following PACF was obtained. As depicted in the figure, the partial autocorrelation function is decaying in a slow pace toward zero. This is contrary as seen in the AR process where the partial autocorrelation function was dropping to zero in a faster pace. This indicates that using the MA or the combination of them all, that is, ARMA is best that using the AR process (Ruppert, 2011). During the forecasting, the combined and segmented forecasting models were used. This included the first order autoregressive model (AR 1), AR (2), AR (3) and the moving average model (MA). This will include the use of the forecast error and all the independent variables used. The combination of the AR and MA is known as the ARMA (p, q) process where the letter ‘p’ represents the term number in the AR function and q representing the term number in the MA functions (Ruppert, 2011). These models are designed to capture the fluctuations that aid in predicting the future trend. The consumer price index has a significant trend as depicted in the figure below. The real bank rate from the observation does not comprise of any long term trend. However due to the correlation of this series with the time trend, a positive drift is expected in the future. Forecasted Inflation Rate Graph 1.6: A Graph on the forecasted Inflation rate for the UK for the years 2010- 2012 The graph above has been plotted from figures that were forecasted using the forecasting models mentioned above. As the graph depicts, the inflation rate from the years 2010 to 2011 declined rapidly. From the years 2011 to 2012, the inflation rate has been increasing while depicting inconsistent trend. This is contrary to the actual figures of the inflation rate that depict an increasing trend from the years 2010 to date (Rao et al, 2012). Phillips Curve Given the change in the unemployment rate, the rate of inflation reduced with the increase in the unemployment rate. The following is the correlogram appearance when the two variables were intertwined. Graph 1.7: A Graph showing the correlation of inflation and lagged unemployment rate Conclusion Given the seven variables in the econometric views, this report has analyzed the figures and forecasted the inflation rate for the next one year.ths has been done through the use of the different structural and non structural models used for forecasting. The report also carried the unit root analysis to determine whether the series was stationary or nor. Having found the series not to be stationary, the report also employed the use of another model to transform the series from non stationary. The findings suggested that the bank rate and the inflation rates had a relationship. The UK also has introduces a constant bank rate of 0.5 percent. This implication on the models influenced the forecasting criterion. References Abelson P. W. and Joyeux R. (2000). Economic forecasting Australia: Allen and Unwin  Michael K (2002). Evans Practical Business Forecasting. USA: Blackwell Publishers ltd. Rogers S. and Ami S (2013). UK Inflation since 1948. Retrieved from http://www.guardian.co.uk/news/datablog/2009/mar/09/inflation-economics Ruppert D. (2011).Statistics and data analysis for financial engineering London: Springer sciences and business media.   Subba T. Rao, C.R. Rao, Suhasini Subba Rao, Calyampudi Radhakrishna Rao (2012). Time Series Analysis: Methods and Applications. Great Britain. Elsevier B.V Terry J. W. and Keith Parramore (2007). Quantitative Methods for Finance. London: Thomson learning. Tejvan Pettinger (2011). History of Inflation in UK. Retrieved from http://www.economicshelp.org/blog/2647/economics/history-of-inflation-in-uk/ United Kingdom Inflation Rate History - 1989 to 2013 (updated March 2013). Retrieved from http://www.rateinflation.com/inflation-rate/uk-historical-inflation-rate?start- year=1989&end-year=2013 Read More