Explaining Price Inflation in the UK: 1971-92

Abstract

The late-1950s and 1960s were, by recent standards, a period of low and stable inflation11'. Since then, however, inflation has been both higher and more volatile peaking above 24 per cent in 1975 in the wake of the quadrupling in the world price of oil. As a consequence, the control of price inflation has become a central concern of macroe conomic policymakers. In the 1970s, the policy response was often to rely on some form of direct control of prices and earnings through incomes policies. By contrast, the Conservative administration from 1979 onwards eschewed all forms of market interference instead relying on the more explicitly macroeconomic policies of monet ary control. At first, these took the form of announced targets for the broad monetary aggregates (initially £M3), but through the 1980s the specification of the Medium Term Financial Strategy (MTFS) evolved to allow a more flexible assessment of 'monetary con ditions' which allowed a wider range of indicators to be monitored. Nevertheless, the primary aim of policy remained the control of inflation. The commitment of sterling to the exchange rate mechanism in February 1990 was a logical extension to this approach. The fail ure to maintain this policy is, by now, well known and the subsequent relaxation of policy in the wake of ERM departure has clearly represented a shift in emphasis away from pure inflation targeting towards a more active concern for the maintenance of output. Nevertheless, recent policy statements, in particular with the announcement of an inflation target of 1-4 per cent for the forthcoming year, have been at pains to preserve the role of the inflation objective in the overall policy framework. If inflation is to play such an important role in the policy framework, it is crucial to be able to explain its behaviour. The objective of this note is to do this by employing the system of estimated wage and price equa tions embodied in the National Institute macroeconomic model. Obviously, inspection of the individual equations alone cannot tell the whole story since wages and prices are simultaneously determined. Consequently, one needs to derive the reduced form of the wage-price system in order to decompose the explanation of the inflation path into contributions from each of the explanatory variables and residuals in the system. We adopt a similar method ology to that described for the Treasury model in Rowlatt (1993) although our analysis differs in an important way because of the forward-looking nature of our system. As in this previous exercise, our explanation of inflation concentrates on its proximate causes, since we treat all the non-price variables, e.g. unemployment, world prices, capacity utilisation, as exogenous to the wage price system despite the fact that many of these are endogenous in the full Institute model. This will tend to overstate the predictive power of the complete model and indeed, on this basis, the short term forecasting ability of the system is fairly accurate. This is especially the case if we assume that the lagged value of inflation is known. It is more informative, in seeking to 'explain' the prevailing rate of inflation, if we decompose both the lagged and contemporaneous effects into the 'quasi-exogenous' fac tors. This allows us to decompose the historical trajec tory of inflation into those effects arising from world price movements, domestically generated influences and an unexplained category. The plan of the rest of the note is as follows. First, we briefly describe the main measures of price inflation and how differences in definition have recently caused vari ations amongst the most commonly adopted inflation measures. We describe an underlying measure of inflation which largely resolves these definitional differ ences. Secondly, we describe the wage-price system of the National Institute model, with particular reference to the theoretical framework of imperfect competition in goods and labour markets. Finally, we conduct a diagnostic breakdown of inflation conditioned on the variables used in the wage and price equations.