The History of UK Inflation

Niraj Shah
Stone & McCarthy Research Associates
28 July, 2006

The UK Office of National Statistics has compiled a composite price index to analyse consumer price inflation since the year 1750. The index was obtained by linking together indices from several different official and unofficially published sources. While comparisons further back in time should be regarded more as approximations, the measure should be useful in looking at long-term trends in inflation and perhaps indicate what the future holds.

Chart 1 is based on a linear scale and shows that an almost exponential surge in prices has occurred since the Second World War. However, it is important to note that the graph is slightly misleading as it overstates the rate at which this change takes place in later years. This is because a doubling in price from say 10 to 20 appears as a much smaller vertical distance on the scale than a doubling in the price index from 100 to 200. Chart 2 overcomes this problem by using a logarithmic scale and is more elucidating in showing the rate at which inflation has actually crept up in the post-war period.

General Trends in Inflation
The index shows that overall prices rose by around 140 times between 1750 and 2003 in the UK. However, for nearly two centuries between 1750 and 1938, prices rose by a little over three times. It is only since the Second World War that prices have increased more than forty-fold. In fact, in the period between 1750 and 1800, prices roughly doubled but were then at about the same level over the next 100 years. Short-term fluctuations prior to 1914 were largely due to harvest quality and European wars.

The First World War triggered prices to double between 1914 and 1920. Yet the most rapid price hikes occurred in the early years of the Second World War and between 1973 and 1981 when prices more then tripled on the back of a series of supply shocks that started with a quadrupling in the world price of oil in 1973. Indeed, the 1970's from that point saw consumer price inflation come in above 10% in nearly every single year, with UK inflation peaking at 24% in 1975.

Yet each decade after the 1970's has seen annual inflation rising by a smaller rate then in the previous decade. The ten years from 1982 to 1991 has seen inflation above 4% in the majority of years and below this every year since, with inflation coming in at or below 2.5% so far in the noughties.

What Has Caused the Inflation Rate to Change in the Past?
Whilst it is beyond this piece to analyse the historical causes of inflation, it is clear that apart from government policy, the major changes in the inflation rate have been due to supply shocks.

Positive supply shocks have curtailed inflationary pressures and include technological changes that have reduced costs and increased productivity as seen in the industrial revolution in the late 18th and during the 19th century. In the modern day, the development of the Internet is also argued to have helped earlier on in lowering inflation by reducing costs and increasing price transparency, whilst the abundance of cheap labour has enabled China to produce and flood global markets with inexpensive consumer goods.

Negative supply shocks have fundamentally been rooted in conflicts and wars that have restricted stocks and in turn seen prices of these goods surge as seen in the modern day by the oil shocks of 1973 and 1981. Globally, the supply side shocks led to inflation rising above 10 per cent in the major industrialised world, with the UK joined by the US, Japan, France and Italy in struggling with double digit inflation in 1974.

Does History Repeat Itself?
Inflation is currently creeping up all around the world on the back of higher energy prices. Indeed the UK saw annual inflation rise further above target to 2.5% in June. Yet today's inflationary pressures are being driven more by the demand side, as an insatiable appetite for energy from China and India perpetuates rising prices during concerns over future supplies. This is the flip side to China's success in producing cheap goods.

However, with inflation edging up almost everywhere, is there a risk of a repeat of the 1970s? A burst of double-digit inflation seems unlikely. For one thing, the present trend is not fundamentally based on a negative supply shock. Moreover, prices escalted further in the 1970s due to a series of policy errors. Policymakers now appear to have learnt from history. Moreover, the UK central bank has joined other central banks in becoming independent and more focused in pre-empting inflationary pressures.

The Final Lesson
Interestingly, talks of risks of global deflation now seem ridiculous and completely obsolete. Yet it was only a few years ago that academics and policymakers were seriously concerned over this possibility. History seems to show that whilst there have been periods of deflation; they have not lasted. The only major period of price decreases was during the Great Depression of the 1930s, which saw the surge in unemployment push wages and profits perpetually lower. Prices have risen in every year since 1936. If long-term history is a guide, perhaps the biggest lesson that can be taken is that inflationary pressures will continue to remain and policymakers should always keep their eye on the ball. Inflation does not die but is immortal.

-Niraj Shah
Stone & McCarthy Research Associates
email: ward@smra.com

© 2006 Stone & McCarthy Research Associates - Reprinted with permission

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