April’s chart shows that inflation in the UK is lasting longer and staying higher than much of the OECD. We can see that, while inflation dropped 0.3% in the UK in March, inflation fell by 1.6% in the Eurozone; in the US, it peaked last June. Food inflation remains at 19%; energy inflation at 67%. Why is the UK struggling to take the wind out of inflation’s sails – and is there cause for optimism?
First, the primary cause for the disparity between the UK, Europe and America is energy prices. Once energy, alcohol, tobacco and food are removed from CPI – otherwise known as the core rate – we can see that UK inflation is only 0.5% higher than the Eurozone, and 0.6% higher than the US.
Gas prices have risen by 133% since the beginning of the war in Ukraine, due to sanctions and destroyed supply lines. Meanwhile, reopening post-COVID has pushed up demand. Even though the UK does not directly rely on Russian gas (at only 4% of supply), unlike Eurozone nations like Germany, competitors in the Middle East and America have been able to drive up prices. Energy has been the major force behind UK inflation.
Britain has therefore been particularly vulnerable to a bout of enduring inflation. The UK gets 40% of its energy from natural gas, compared to a Eurozone average of 21%. What’s more, energy and food make up a large proportion of household budgets already, giving them even higher weight on Britain’s inflation tally: energy contributes 0.6% more to inflation in the UK than Germany. Brexit has only exacerbated inflation on imports, creating higher administrative costs. Moreover, a weaker pound, following political and macroeconomic turmoil, makes imports even more expensive.
Another cause for the disparity between the UK and Eurozone is the effect of the British energy price cap. As it is adjusted only every three months, inflation figures have been distorted. In the UK, the cap was adjusted for the first time after the war began in April last year; and as inflation is calculated on an annual basis, last year’s price rises should only be factored in this month. Additionally, while the energy price guarantee can prevent prices from going up, it can also prevent them from going down. Even though wholesale prices have fallen, the UK government will simply find itself covering less of the gap between the prices charged by suppliers, and the capped price faced by consumers. In contrast, countries such as Italy have focused on lowering VAT on energy by 17%, as well as providing tax credits of 40% for gas, which will continue to bring prices down even at lower wholesale rates. Finally, it is possible that a less competitive energy market has seen slower movement in the UK – as consumers know they are protected by a cap, they are less responsive to lower prices from different firms, encouraging suppliers not to compete over price. Firms contend that the cost of renewable infrastructure has forced them into a higher retail price.
An alternative explanation for British exceptionalism is the UK government’s preference for direct support over widespread price-cutting. Through the cost of living crisis, the UK government has provided the winter fuel payment, cold weather payment, and the alternative fuel payment. This means that while inflation appears higher, the level of support would have been no different had the UK government brought down their price guarantee, and payed a bit more of each household’s energy bill. Using funds on tax cuts as they did in Italy would have likely brought down inflation, but would have had a smaller effect on the cost of living crisis (firms will take producer surplus from a tax cut, by simply adding some of the cut to profits). Higher inflation than the Eurozone does not mean higher cost of living.
But while energy price inflation is likely to see some decline in the coming weeks, perhaps more worrying is the core rate. Yes, it remains similar to the Eurozone – but forecasts predict a core rate of 4.3% in 2024, dropping slowly to 3.8% in 2025. With a central Bank target of 2%, a consistently high level of inflation will put strain on households. This is what Andrew Bailey is most worried about when he talks of a “very, very fine line.”
One cause for core inflation is the UK’s unusually tight labour market. Vacancies now roughly equal the total number of unemployed, while wage inflation is at 6.9% compared to a Eurozone average of 5.2%. And while economic inactivity has returned to pre-pandemic trends across Europe, this is not the case in the UK. One reason for the jump in vacancies was a spike in retirement over the pandemic, as older people saw the lockdowns as an opportune time to retire. Poor health increased over the pandemic, leading to early retirement: physical health was particularly bad in the UK, due to long NHS waiting times and an ageing population. Mental health also deteriorated while little support was provided, and some elderly people concluded that work was not worth the stress. What’s more, furlough gave employees the time to experiment with retirement, and many decided that they preferred it. Now that the pandemic has ended, demand has risen rapidly, exposing significant vacancies. These forces have only been intensified by ongoing NHS strikes, and by the struggle to expand the working population after Brexit. Ultimately, the existence of these vacancies has given employees more wage-setting power, and forced firms to increase wages to attract workers. Wages may stay high for a generation, and central bankers must worry that inflation will become embedded in the UK economy.
The central bank is hoping that higher interest rates can help reduce vacancies and stabilise wages. But this is undoubtably a treacherous endeavour: in order to bring down demand to a point where firms no longer wish to fill these jobs, the Bank of England may find that it has caused a recession. A wave of retirement has meant that it is higher level jobs that have seen the widest vacancies, and wage inflation: but these are also harder to fill, meaning inflation may still stick around for a while longer. And low business confidence means that interest rates could pass a tipping point, leading to economic calamity. Andrew Bailey hopes that inflation will hit 2% by 2024. But in the meantime, we can only look on tentatively, as he plays a balancing act which we might all be paying for, for years to come.
As noted in a previous chart of the month.
Our Question of the month:
Is 2024 too soon for inflation to return to it’s 2% target?
Written by Thomas Potter