Inflation is rising in the UK. Will this pass through, persist or become permanently entrenched? This is a key issue for the economy, for policy and for the financial markets.
The annual rate of consumer price inflation rose to 2.1% in May. It has risen steadily from a recent low of 0.2% last August, and reached 0.7% in March and 1.5% in April, before breaching the Bank of England’s 2% target in May.
The monthly increase in both April and May was a sizeable 0.6% and inflation is set to spike higher over the remainder of the year. The UK is not immune in facing such inflation pressures. This trend is evident across all major economies, as they emerge from the pandemic.
Over the last week, however, the inflation debate heated up in the UK, with conflicting views about the inflation outlook between the Bank of England’s outgoing chief economist, Andy Haldane, and its Governor, Andrew Bailey.
Haldane warned that inflation could rise by more than the Bank expected this year and persist. In contrast, the Governor, giving his annual Mansion House speech on policy, highlighted the different pressures on the inflation outlook and stated how the official Bank view is that the current rise will be temporary.
Over the last decade, monetary policy has helped feed high asset price inflation and contributed to resulting growing asset and wealth inequality. It is important that monetary policy does not feed more widespread inflation now.
The impact of domestic inflation pressures
Since the 2008 global financial crisis the UK has suffered two bouts of inflation, both linked to sharp falls in the pound that fed higher imported inflation – in the aftermath of the global financial crisis and following the 2016 referendum. While both bouts triggered a squeeze on living standards, as wage growth did not rise enough to compensate, inflation did not persist for a prolonged period as domestic inflation pressures remained subdued.
Sterling is now firm but external inflation pressures have risen as commodity prices are higher. What happens to domestic inflation pressures is key.
Many macro forecasters focus on output gaps – namely whether there is spare capacity in the economy – and on expectations to help gauge whether there is an inflation risk.
Thus, the fact that the economy is still below its pre-crisis trend, with unemployment higher despite the economic rebound, plus the still low, embedded nature of inflation expectations, is nonetheless leading to the consensus view that inflation risks are low.
The UK is rebounding strongly and looks set to return to its pre-pandemic level before the end of the year. While this is welcome, the Governor was keen in his Mansion House speech to point out that this would leave the economy having still suffered from two years of lost growth, relative to pre-pandemic expectations.
Avoiding premature policy tightening was the Governor’s message, echoing the view emanating from the US Federal Reserve.
Tightening policy: the importance of timing
Pent-up demand and supply bottlenecks are contributing to higher inflation and, in the view of the Governor this will be temporary. While it is important that the post-pandemic rebound is not choked off by premature policy tightening, it is also critical the recovery is not undermined by inflation that persists, forcing more aggressive tightening later. The decision on when to tighten policy is a judgement call.
I do not see inflation becoming permanently entrenched. Some of the longer-term drivers that have kept inflation low still prevail, although in coming years they may not be as disinflationary as they were before the pandemic.
- Wage inflation has not been a characteristic of recent decades, but that could change post pandemic.
- Globalisation, too, has suppressed inflation, with China in particular exporting disinflation. That, too, could change post pandemic as more redundancy is built into supply chains and activities are on-shored. But even allowing for this, one would expect global competition to remain intense, limiting the extent to which producers and retailers can boost their profit margins and thus keeping inflation in check.
- Technology has also helped to suppress inflation. One would expect this pressure to persist in coming years.
- Then there are inflation expectations. These have remained low, but this could change. In the early 1990s I was in the then small group of economists seeing a move to low inflation, and events at that time carry an important lesson for now. Then the consensus (or groupthink, if one wishes to call it that) was slow to respond and to believe that inflation would trend permanently lower. In time, inflation, rates and yields fell.
Likewise, now, in terms of how sentiment might change, if we were to move to a period of permanently higher inflation, in all likelihood, inflation expectations and forecasts would respond with a lag. That is a danger.
The policy context is key. In the US, for instance, President Biden, in a speech at the end of May, talked of how he wished to see higher wages. If there is a genuine wage rise in the US that could feed rising inflation there and a similar trend could eventually be witnessed in the UK, too.
Policy is key
If central banks move towards a pro-growth strategy, that carries with it an increased inflation risk. Were their mandates to widen – as some are calling for – to incorporate a green or an inclusive agenda, then financial stability risks would rise.
Therefore, the actions and mandates of central banks are key and we need to watch what they do as well as listen to what they say.
In the UK, excessively loose monetary policy risks inflation not passing through, where it returns to 1% to 2%, but persisting, to around 3% to 4%. I would advocate a calm, measured monetary response, and not panicking, with a gradual, predictable and immediate tightening of monetary policy.
The exit strategy – as we have pointed out previously – would mean halting the printing of money through quantitative easing, and eventually reversing it. This would mean delaying raising interest rates until later, when the economy is stronger.
The message, though, from the Mansion House was that – with the economy still below its pre-crisis trend – the Bank is not planning to tighten policy anytime soon. Policy actions will be key in determining whether higher inflation passes through or persists.
Please note, the value of your investments can go down as well as up.