“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” – Milton Friedman, Nobel prize winning economist.
A series of unfortunate shocks, starting with the pandemic, but also supply bottlenecks, the energy crisis, and more recently the war in Ukraine have morphed into a more serious inflation problem for the UK. These shocks are no longer transient as they have started to impact wage negotiations and settlements, and in turn, higher wage costs are impacting prices and inflation.
The Bank of England (BoE) has so far taken a steady approach to the inflation risk, and the Monetary Policy Committee (MPC) still appears to be more concerned by slowing growth rather than the risk of a wage-price inflation spiral taking hold. Investors, however, are questioning the Bank’s willingness to promptly bring inflation back under control, and are punishing sterling as a result.
The US Federal Reserve (Fed) increased the target range of the US federal funds rate by 75 basis points (bps) in June, the biggest such move since 1994. Investors expect the Fed to do the same again at its next policy meeting. In contrast, the BoE increased its main policy rate by 25 bps, disappointing investors who had been hoping for a similarly aggressive approach to help restore price stability.
Unless the BoE takes a leaf out of the Fed's book, then investors are likely to remain concerned about higher inflation for longer, and sterling could continue to underperform. In this note, we explore the evidence available on inflation pressures in UK, and explain why the BoE is behind the curve, at risk of higher inflation becoming entrenched for many years.
Higher inflation post pandemic
The Covid-19 pandemic caused many countries including the UK to implement severe lockdowns through 2020 and 2021, restricting activity in almost all sectors. The government stepped in to shield households and firms through the provision of furlough schemes, general subsidies and loans. Meanwhile, the BoE cut interest rates back to their lows, and restarted quantitative easing (QE) to provide as much stimulus as possible.
The actions of policymakers limited the rise in unemployment and helped households get by. Indeed, households managed to increase their savings tremendously through this period, as pent-up demand rose. Not being able to eat out at restaurants, or go to the cinema, spending on services fell sharply, but instead rose for goods. Working from home meant demand for IT equipment rocketed, along with goods associated with home improvements.
Shortages of goods started to appear as firms struggled to keep up with demand. As restrictions were lifted on workplaces, this eased, but then demand shifted back towards services. Service providers struggled to get back up to speed, especially as many were forced to let staff go through the pandemic. Replacing staff became difficult as some of those that are medically vulnerable left the workforce, while others decided to move to sectors less impacted by Covid. According to the Office for National Statistics (ONS), 193,000 people left the workforce with long-term sickness between February 2020 and January 2022. A further 139,700 left for “other” reasons, thought to be related to the pandemic.
Staffing problems have only been exacerbated by Brexit. In the past, UK companies had little trouble attracting more labour from the continent to fill positions within a short time-frame. This is no longer an option, leaving record high unfilled job vacancies, at a time when unemployment is very low. Power in the labour market has returned to staff as wage growth has risen sharply in the private sector, while the public sector is seeing increased disruption through industrial action.
BoE raising interest rates, but not fast enough
Three of the nine MPC members voted to raise interest rates by 50 bps at their latest meeting on 16 June 2022. They were out-voted in favour of the eventual 25 bps increase. Interestingly, all three in the 50 bps camp happened to be external members. One of them, Dr. Catherine Mann, recently gave a speech warning that a delay in normalising monetary policy could weaken sterling further, which risked exacerbating high UK inflation.
Mann explains that “…the incoming data on inflation show increasingly domestic embeddedness, persistence and momentum: 90% of CPI categories are rising at rates greater than 2012-2019, and the distribution of expected inflation outcomes have shifted rightward and with a fatter right tail.” In effect, Dr. Mann was saying that the risk has increased for inflation to come in higher than forecast.
Indeed, the initial reaction in markets to the decision to only hike by 25 bps was to push sterling lower – an indication that investors had expected a larger rise. Even more perplexing was that the MPC minutes revealed that the committee had raised its near-term forecast for Consumer Price Index (CPI) inflation to peak above 11% later this year.
Is the BoE tightening policy appropriately, or is it moving too slowly, and therefore risking a prolonged bout of inflation?
UK has highest inflation in the G7
The latest set of inflation results show that the UK currently had the highest rate of inflation in the G7 in May, and is still expected to have the highest rate in 2023 according to Consensus Economics (see chart 1, below). Indeed, speaking at a conference of central banks in Sintra last month, BoE governor Andrew Bailey suggested that the UK could suffer high inflation for longer than other nations.
Given the scale of the inflation problem in the UK, many would reasonably argue that the BoE needs to tighten policy a little less “gradually” – a favourite term amongst central bankers. But it seems that the majority of the MPC has not yet recognised the severity of the situation.
Transitioning from “transient” inflation
Up until a few months ago, the Bank had lent heavily on the notion that the main causes of rising inflation were external, and largely transient or temporary forces. As monetary policy works with a delay, it was argued that central banks should ignore short-term inflation shocks. By the time higher interest rates would work to slow demand, the impact of the shock would have passed, goes the logic.
Rebounding global energy prices were the main culprits at first. As shown in chart 2, the contribution from energy to headline CPI inflation swung from -0.6 percentage points (ppts) in the second half of 2020 to +1.5 ppts by the end of 2021.
The war in Ukraine has exacerbated the situation, pushing global oil prices higher. As a result, energy inflation continues to be a large contributor to CPI inflation (accounting for 3.5 ppts of the current 9.1% year-on-year, or y/y rate recorded for May), and is likely to rise further in coming months.
The UK’s energy price cap for households limits price adjustments based on market prices to twice a year. This acts to delay the passthrough of recent increases in wholesale prices to end consumers, and is one of the reasons the UK is expected to have higher inflation for longer.
Beyond energy inflation, other factors have risen in importance. Another largely external force, food prices, has also seen a spike up in recent months. Again, the war in Ukraine has been a factor as it has hit exports of crops from the region, while the rise in the price of natural gas has also raised the cost of fertilisers and other chemicals for farmers. As a result, food and non-alcoholic beverages inflation rose to 7.5% y/y in the latest release (for May 2022) – its highest rate since June 2011. Moreover, latest wholesale prices suggest that the UK will see a continued rise in food price inflation until the middle of next year.
The war in Ukraine has clearly complicated the outlook for food and energy inflation. There is still a significant risk that prices could yet rise further, but they are unlikely to increase by as much as they have already risen. This should mean that as we progress into 2023, the contribution to annual inflation will fall away. However, we are now seeing inflation spreading, and this is a major concern. Core inflation (excluding energy, food, alcohol and tobacco) reached 6.2% y/y in April – a 30-year high - before falling back to 5.9% y/y in May.
At the meeting in Sintra, Bailey said: “The word transient has become discredited, but it isn’t really in one sense because that was built on a single supply shock idea.” He goes on to argue that a series of back-to-back temporary shocks, including Covid and the Ukraine war, can no longer be treated as temporary as they are starting to impact households’ expectations of inflation.
Inflation pressures are broadening out
Though the inflation story began with higher commodity prices, there is growing evidence that it is now spreading to other parts of the economy. Historically, the input prices series from the Producer Price Index (PPI), which predominantly reflects commodity prices in sterling, has led the output prices series by about three months. This in turn provided a reliable lead for CPI goods prices by another three months.
However, as shown in chart 3, below, since about the middle of 2021, output price inflation and goods price inflation have been about twice as high as they should have been according to input price inflation. That is to say that commodity price increases only explain about half of the rise in goods price inflation seen today in the UK.
Initially, supply bottlenecks were to blame, which allowed producers to charge more than during usual times. However, we have found that wage inflation seems to explain much of this divergence. When taking the difference between output and input prices (the premium being charged), and comparing it to whole economy total wage growth, we find a close relationship, especially since the start of the pandemic (chart 4, below).
In the past, companies had smoothened such fluctuations by taking a hit to profits. But it seems that they are now passing on those costs, as this is evidence that wage inflation is having an impact on goods price inflation.
While goods inflation is important, it is impacted by so many external factors (such as food and energy) that central banks tend to put less emphasis on these categories. Services inflation on the other hand is mostly driven by domestic factors, and so is more sensitive to the underlying strength of the economy.
Chart 5 below shows goods and services inflation separately, with goods inflation now reaching 12.4% - much of it driven by energy inflation. Meanwhile, services inflation has reached 4.9% - its fastest rate since April 2011. However even within services, there are categories driven by energy prices.
To get a true measure of domestic services price pressures (or core services), we strip out transport services as shown in chart 6. Here we see that core services is the biggest driver of overall services inflation, and not transport services. This is yet further evidence of growing domestic price pressures.
The BoE should be seeing these forms of inflation as a threat to price stability. Monetary policy is being tightened, but there are questions about how high interest rates need to rise to. In our view, the level of interest rates needs to rise above what is considered to be neutral, of between 1% and 2%. Our forecast assumes the main policy rate will rise to 2.25% by February 2023 and then remain there through next year. However, interest rates may need to rise even higher to bring inflation back under control. There are three reasons for this.
First, fiscal policy has been working against monetary policy of late.
The BoE is raising interest rates to slow demand, yet the government has been providing additional payments and benefits to households, mainly to help with the rise in energy and food prices. However, this works to prop-up aggregate demand in the economy, and therefore contributes to higher price pressures.
While we wait to learn who will take over from Boris Johnson as the new prime minister, we note that the vast majority of candidates are campaigning on the basis of cutting taxes to boost growth.
Second, interest rates have become less effective as a policy tool. Households have taken advantage of low interest rates to reduce outstanding debt. Less than a third of households have a mortgage at all, and of those borrowers, less than a fifth are on a floating rate mortgage, while more than half have a fixed rate product of two years or more. By our calculation, only around 15% of households would be impacted rising rates in the next two years.
Finally, weakness in sterling, especially against the US dollar is significant. The depreciation has driven up the cost of imports, and the cost of commodities priced in US dollars. The pound has fallen by 11.8% so far this year (to 12 July) against the greenback, with 3.7 ppts occurring in the last month alone. The US dollar typically attracts safe haven flows during times of greater economic uncertainty, and recent months have shown a similar pattern. It can take up to two years for the full cost of weaker sterling to be realised and prices to adjust.
Why would the BoE hike by less and more slowly?
In response to a question about the weakness in the pound at Sintra, Bailey replied: “I’m not surprised by the way path [SIC] of sterling…I think that the UK economy is probably weakening rather earlier than, and somewhat more than others.”
Indeed, forecasters have the UK as one of the weakest economies for this year and next, though this is mostly as a function of the higher inflation being forecast (see chart 1 earlier). But in the near-term, the UK economy appears to be slowing markedly.
Private business surveys such as the purchasing managers’ indices (PMIs) are down from their recent post Covid re-opening highs, but are still reporting positive growth in activity by remaining above 50 (chart 7, below). However, both the construction and services PMIs have fallen below their long-run averages. All three sector surveys are expected to decline further, as the economy adjusts to higher inflation and interest rates.
The latest GDP release showed the economy grew by 0.5% in May – beating consensus expectations after the economy contracted in April by 0.2%. The UK’s GDP data will be choppy in coming months, and will be less useful than normal.
The winding down of the national health services’ Covid Test and Trace and vaccination programmes has impacted health services activity, while recent industrial action has also disrupted transport services. Moreover, the UK enjoyed an extra public holiday in June to mark Her Majesty the Queen’s Platinum Jubilee. The additional holiday will have reduced output by a day which taken together with the other factors, are likely to have caused a sizable contraction in the second quarter, followed by a third quarter rebound. The Golden Jubilee of 2002 caused a June GDP contraction of -2.2%, while in 2012, there was a -1.7% hit to output in June as the country celebrated the Diamond Jubilee. With GDP being distorted, private businesses surveys such as the PMIs are likely to be watched more closely in coming months.
Another important indicator that is providing a warning signal is the sentiment amongst consumers. The GfK consumer confidence index hit a new record low in June, suggesting that households may be about to cut back spending sharply in the near future (chart 8, below).
Spending by UK households is very cyclical, and shocks or concerns over employment tend to prompt an increase in pre-cautionary savings, causing spending to slow, and sometimes fall. However, households have saved more than normal during lockdown, with much of these surplus funds still intact. This should mean that households have a little more of a safety buffer in place before they need to cut back spending.
Of course, the distribution of savings is concentrated amongst the wealthier households, which reduces the power of the excess savings. And so, if spending follows consumer confidence lower, than the UK economy is very likely to fall into recession.
Another reason why the Bank may not raise rates too aggressively is that headline inflation is forecast to peak in October (the next rise in the energy price cap), before slowing over the course of next year. By then, it will be difficult to justify to the public further rate rises when growth is weak and inflation is falling back, albeit still above the BoE’s target.
At that point, a judgement call will be required by the Bank’s MPC. Underlying inflation, which we have shown is rising, will probably continue to build even if headline inflation, especially energy inflation, starts to come down. The Schroders forecast is that the MPC will stop hiking in February next year at 2.25%. But the committee could, and possibly should, keep raising rates to a more restrictive level.
At present, our view is that the BoE is behind the curve and there is a risk inflation will become entrenched for many years as a result.