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Inflation: do the latest data suggest it will be temporary?

Today’s inflation figure was a surprise. At 2.1% it is below what was predicted by many economists, and a decline on the previous month. Temporary bottlenecks in car markets are pushing up prices, with a gap opening between US and UK inflation rates.

The UK’s headline measure of inflation, the Consumer Prices Index including homeowner costs (CPIH), increased by 2.1% in the 12 months to July 2021. This was down from 2.4% in June and reversed a four-month upward trend in price pressure.

Prices of women’s clothing and computer games fell in summer sales, with three quarters of the sections in the basket of goods and services measured falling overall. Clothing sales in stores were wiped out by the pandemic last year, so a return to normal discounting this summer amplified their negative contribution to prices.

Of the prices that rose, the key driver was transport, which saw its biggest upward contribution to inflation in a decade. In July, petrol prices reached their highest level since 2013, while during the baseline period last year, prices were still recovering from reduced demand during the first wave of the pandemic. This so-called ‘base effect’ led to a high growth rate of fuel prices.

Second-hand cars also drove transport prices up this month. Traditionally their prices fall during the summer, but a global semiconductor shortage has held back car production, pushing people who would have purchased a new vehicle into the second-hand market. Higher demand has been met with lower supply too. A fall in purchases of new cars last year means there are less one-year old cars available in 2021.

Out of sync

Used car and petrol prices have risen even further in the US this year, which helps to explain the divergence between UK and US inflation (2.4% versus 6.4% in June, respectively). Figure 1 below shows second-hand car prices rose 41.7% in July in the US compared to only 14.3% in the UK. Common factors for these price rises include semiconductor scarcity for new cars, the reopening of dealerships and a reduced preference for public transport.

Several specific factors are at play in the US. These include three rounds of Federal stimulus cheques, totalling $11,400 for a family of four, paid over the past 12 months to April this year; and rental car companies that sold off their fleet in 2020 (depressing prices) now buying back swiftly. Lower fuel duty in the US also means that while prices have gone up similarly in both countries, the proportional increase in pump prices (duty plus fuel price) has been much higher in the US.

Figure 1: Second-hand cars 12-month percentage price growth in the UK and Unites States

Source: Office for National Statistics - Consumer Price Inflation, U.S. Bureau of Labour Statistics - Consumer Price Index for All Urban Consumers

Speedy recovery

Weaker than expected headline inflation is good news for the UK economy as it means that real wages – i.e. pay adjusted for the rate of inflation – are higher. Strong regular earnings growth of 3.5-4.9% year on year was reported yesterday by the ONS (stripping out the base effect of falling wages last year and the furlough scheme). Taking today’s inflation figure into account, average regular pay of £541 in June 2021 is now worth £1.55 more per week in real terms than it would have been based on last month’s inflation rate.

Slower price growth also soothes concerns that the economy might be overheating. Prices strongly increased month on month between March to June and it was expected that the continued easing of lockdown would accelerate this. But despite the release of pent-up demand, supply chain bottlenecks in raw materials and a services sector struggling with record high staff vacancies, this did not happen last month. Prices were flat between June and July.

This is surprising as the Bank of England expects inflation to be double its 2% target by the end of the year, and some economists, including Larry Summers in the US, have warned that the unprecedented level of government support would stoke inflation. This prompted Mr Summers – a previous US Treasury Secretary -  to call it “the least responsible macroeconomic policy we’ve had in the last 40 years”. This harks back to the high unemployment and inflation of the 1970s following successive oil price shocks, where inflation touched 25%.

Despite these concerns, Figure 2 below shows that inflation has been nowhere near that level since. Today, most economists, including the governor of the Bank of England, are convinced that higher inflation – if it comes – will be temporary.

Figure 2: CPIH inflation - percentage change over 12 months

Source: Office for National Statistics

The evidence from July supports this for several reasons. First, because July 2020 coincided with the reopening of pubs, restaurants and hairdressers, the statistical gremlins (base effects) that increased June’s annual inflation figure to 2.4% actually bring down the headline rate this month. Second, areas of increase such as the second-hand car market are unlikely to remain elevated. Evidence from the US shows that used-car price increases are already falling back from their double-digit growth. Demand and supply imbalances created by the reopening are also likely to subside if coronavirus cases continue to fall and more people feel safe to come back into work. For persistent inflation to set in, a permanent increase in the bargaining power of workers would be needed. Figures such as today’s make this seem unlikely.

The free-market economist Milton Friedman famously described inflation as “always and everywhere a monetary phenomenon”. While the high government spending recently witnessed may be a pre-condition of inflation, the sustained labour market tightness needed for inflation to set in is absent. This makes policy-makers confident that, for now, we are not about to endure 1970s level price growth once more.

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Author: Ben Pimley
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