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Inflation battle means continued interest rate rises for the UK

Despite the risk of causing a recession, the Bank of England may need to aggressively hike as energy price inflation spills over into wider economy

18/05/2022
Interest_rate_news

Authors

Azad Zangana
Senior European Economist and Strategist

Annual UK inflation based on the consumer price index measure surged to a 40-year high in April, reaching 9% compared to 7% year-on-year in March.

The latest jump was primarily due to the rise in the government’s energy price cap, which had previously sheltered households from rising wholesale energy prices. The cap works to delay increases (and decreases) to two changes per year, though this may be reviewed in the future due to the financial difficulties that energy companies have faced.

Housing and household services, which includes home energy, made up four-fifths of the rise in annual inflation over the month. Yet, despite dominating the latest rise, there are worrying signs that energy inflation is beginning to spill over into other parts of the economy, the so-called “second round” effects.

For example, annual inflation in restaurants & hotels has reached 8%, compared to 5% just two months ago. Inflation within recreation & culture services is up to 5.9% compared to 4.7% in February.

When focusing in on core services inflation, by stripping out transportation which is impacted by energy, we see that prices rose by 4.1% in April. This is the fastest rate since October 2002 and significantly higher than the long-term average of 2.5%.

The main risk for the UK economy is that the largely external price shock caused by higher energy prices causes domestic prices to respond, followed by wages.

As shown from the latest labour market report, the supply of workers is very limited. The release showed the unemployment rate falling to just 3.7% - its lowest level since 1974. This will have contributed to annual rate of total private sector pay jumping to 8.2%.

However, the single metric which highlights the extremity of the labour market shortage is that for the first time on record, there are more unfilled job vacancies than unemployed people available to fill those jobs.

In the past, higher demand for labour would have been met by migrants, particularly from the EU. Brexit has now heavily curtailed that option, making it easier for domestic workers to demand higher wages. The risk of course is that higher wage growth leads to ongoing strong demand, and further inflation. This could lead to a stagflationary environment, akin to the 1970s. The only way to bring inflation under control back then was to aggressively raise interest rates and cause a recession.

The Bank of England will of course want to avoid a recession, but even with its own forecast, it has inflation peaking at around 10% at the end of the year, and the economy contracting.

The Bank is likely to continue to raise interest rates this year, and hope that it can reduce domestic demand and ease wage pressures without causing too much damage to the economy.

Authors

Azad Zangana
Senior European Economist and Strategist

Topics

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Azad Zangana
Economics
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