Why Britain has the highest inflation in the G7

Wednesday was not a good time for chancellor Rishi Sunak and Bank of England governor Andrew Bailey to be steering the UK economy.

As G7 finance ministers and central bank governors met in Bonn, Sunak and Bailey had the dubious honour of presiding over the worst inflation in the group of advanced economies.

Official data released on Wednesday showed UK inflation surging to 9 per cent in April, and suggested Britain was enduring the worst of all worlds with its price rises compared with other countries.

Like many European economies exposed to higher gas and electricity prices that have been exacerbated by Russia’s invasion of Ukraine, UK energy costs were 69 per cent higher in April compared with a year ago. The full effects of the war will be felt by British households in October, when the energy price cap is expected to be raised, in a move that is likely to take inflation towards 10 per cent in the autumn.

Meanwhile, the UK labour market is red hot, with unemployment at a near 50-year low, and strong pay growth involving bonuses, according to official data released on Tuesday. In this sense, Britain’s economy is overheating in a similar way to that of the US, and interest rate rises will be needed to cool things down.

Amid the escalating cost of living crisis, the UK’s one saving grace at the moment in international inflation comparisons is that British households allocate only 8.4 per cent of their spending to food, which is beginning to rise sharply in price. IMF studies show that in advanced economies the median proportion is 17 per cent, while in emerging markets it is 31 per cent.

What will concern UK ministers and officials the most is that the country’s inflation problem has more signs of persistence than in many other European countries.

Allan Monks, economist at JPMorgan, highlighted increasing evidence of high levels of inflation “bleeding” from the prices of energy and goods into core services.

He said some of this was because the hospitality industry had resumed charging value added tax at 20 per cent after a period of relief during the coronavirus pandemic, but added: “The underlying gain [in services inflation] was nevertheless firm and indicates a growing domestic, and likely more persistent, component to inflation even as goods pricing moderates.”

With the BoE having a 2 per cent annual inflation target, Kallum Pickering, economist at Berenberg Bank, noted how 80 per cent of the goods and services that the UK statistical agency monitors have price rises exceeding 3 per cent at the moment.

Bailey said on Monday there was not much the BoE could do to stop UK inflation hitting 10 per cent because it was fuelled by global shocks including the Ukraine war and China’s zero-Covid policy, but the fact a wide array of goods and services are recording price rises well above the BoE’s 2 per cent target will be of serious concern inside the central bank.

This situation underpins the case for further interest rate increases, according to Sandra Horsfield, economist at Investec.

She said the spread of inflation to services “ups the ante even further for the Bank of England to respond” because it could not dodge responsibility in this area. “Along with [Tuesday’s] red-hot labour market report, the case for front-loading monetary tightening looks stronger by the day,” she added.

The question for members of the BoE’s Monetary Policy Committee will be whether they can stick to the majority view at their May meeting for a limited number of interest rate rises in the short term, hoping most of the inflation will be extinguished within a year or so. The alternative is to be forced to raise rates significantly to ensure financial pain for households and businesses, and thereby curb actions by people and companies that are at present stoking inflation.

The big worry for the BoE is that high inflation is becoming normal and expected by households, businesses and financial markets.

It risks locking the UK into a so-called wage-price spiral, where workers demand pay rises to match higher living costs and companies raise prices to protect their margins in a repeating, self-fulfilling process. If markets expect inflation to stay high, it gets built into financial contracts ranging from the cost of government debt to the price of infrastructure.

As the BoE MPC said in its May monetary policy report, higher inflation expectations were a concern because if they stayed too elevated, “wage and price-setting are not consistent with inflation returning to the 2 per cent target in the medium term”.

It noted that whether looking at companies’ predictions of their ability to raise prices, households’ views of future inflation or values in financial markets, “expectations for inflation in two to three years’ time remain above historical averages”.

The BoE said longer-term inflation expectations were little worse than three months ago, but that was not hugely reassuring because they were also up on normal levels. “The MPC will continue to monitor measures of inflation expectations very closely and, importantly, how inflation expectations appear to be affecting wage and price-setting,” it added.

If the emerging signs that the UK has the worst-of-all-worlds inflation are confirmed, the BoE will have to raise interest rates significantly. The central bank has not come to that judgment yet, but further bad news on rising prices would force its hand.

Source link

About the Author

Leave a Reply

Your email address will not be published.

You may also like these