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Will inflation take off in the UK?

Inflation is likely to rise from its current low level due to supply shortages and increased spending. The most probable outcome is a range of 2-3% a year, but it could go higher. Any increase above 3% should be temporary as long as fiscal and monetary policy are set appropriately.

Inflation is a general increase in prices in an economy – it erodes the purchasing power of money. The prospects for UK prices are more uncertain now than they have been for many years. As Charles Goodhart discussed in July 2020, there are opposing schools of thought on post-pandemic inflation. This uncertainty can be seen in the economic forecasts published from mid-2020 until now. While the headline forecasts for inflation have been around 2%, the ‘fan charts’ that accompany them show a wide range of possibilities.

Examining the inflation forecast published by the National Institute of Economic and Social Research (NIESR) in February 2021, and looking at the forecast for the end of 2021, there is a 10% chance that inflation will be above 4%. The probability of it being within the 1-3% range that the government sets and the Bank of England targets is less than 50%.

NIESR explains: ‘The fan chart is intended to represent the uncertainty around the main-case forecast scenario shown by the black line. There is a 10 per cent chance that CPI [consumer prices index] inflation in any particular year will lie within any given shaded area in the chart. There is a 20 per cent chance that CPI inflation will lie outside the shaded area of the fan.’

Figure 1: NIESR Inflation Forecast Fan Chart, February 2021.

Source: February 2021 NIESR Economic Outlook, Table 18.

More recently, uncertainty has fallen, partly due to the success of the UK’s vaccination programme and the extension of the job Furlough scheme. The May 2021 NIESR Economic Outlook has the probability of inflation being outside the target range of 1-3% as significantly lower, at 30%.

What does the history of inflation reveal?

Figure 2: Consumer Price Index (CPI): headline annual inflation, 1989-2021

Source: ONS Consumer Price Inflation Tables: CPI Inflation.

While there is uncertainty in the level of inflation, it is important not to exaggerate it. Figure 2 displays UK CPI inflation levels over the past 30 years. The two blue lines represent 1% and 3% inflation, the green line marks the 2% target, and the yellow line marks 5%.

Since 1993, the inflation rate has averaged 2% and been between the two blue lines most of the time. Either side of the global financial crisis of 2007-09, inflation was as high as 5%, and for the four years from April 2008 to April 2012, inflation was elevated above 3% (excluding the ‘dip’ from March to December 2009, when it fell below 3%). There was also an interval of near zero inflation during 2015, and inflation remained below 1% from November 2014 to October 2016. For most of 2020, inflation was also below 1%.

Taking a slightly longer time horizon, the last time there was sustained inflation above 5% was for the three years from 1989 to 1992, peaking at above 7% from August 1990 to March 1992. To find sustained inflation above 10%, you need to go back almost half a century to the ‘Great Inflation’ of the 1970s, when the rate peaked at over 20%.

Certainly, the data of the last quarter century suggest that inflation has been anchored around 2%, sitting at 0-5% throughout this period and spending most of the time between 1-3%. This stability has persisted despite periods of turbulence and uncertainty – there were some large shocks in this period (including the 1997 Asian financial crisis, the bursting of the ‘dot-com bubble’, the global financial crisis and the Second Gulf War). Inflation expectations seem quite stable, reflecting confidence in the Bank of England’s intention and ability to contain inflation.

How could the Covid-19 shock affect inflation?

So, with this historical stability taken into account, what is driving the current uncertainty about inflation? The pandemic was a combination of a supply and demand shocks, which pull prices in opposite directions. As a result, much of the uncertainty stems from the difficulty in predicting which effect will dominate.

Supply-side shocks operate by reducing productivity and/or raising input costs. An adverse demand-side shock reduces demand and can lead to lower prices. Both shocks lead to lower GDP, but their effect on prices and inflation act in opposite directions. The uncertainty is also about whether shocks are transient or more long-lasting: a temporary shock is less likely to lead to a sustained ‘take-off’ of inflation.

Low demand in 2020 was due to two factors. First, lockdown meant people’s ability to spend (or their ‘consumption levels’) was constrained for much of 2020 and early 2021. Second, jobs were lost and businesses went bankrupt. These same job losses and bankruptcies caused uncertainty as people became more cautious. Normally, this sort of negative demand shock causes a fall in inflation, as firms are unable to raise prices, and workers are unlikely to be able to bargain for higher wages, as seen during the inflation ‘dip’ in 2008-09.

The pandemic supply shock was also important. Social distancing, the difficulty of travelling to work and other related factors led to a reduction in supply in many sectors. The supply shock has continued even without lockdowns. For example, restaurants and bars cannot seat as many people as normal and have to take extra cleanliness measures.

The supply-side effect is not just on services: there are additional costs to manufacturing as well, and of course services are used as intermediate inputs in manufacturing. This will raise what it costs a firm to provide a given unit of their service (the ‘marginal cost’), and this will lead to higher prices (inflation).

Further, this simple supply-and-demand analysis ignores the price-setting behaviour of firms. The price set by firms includes a ‘mark-up’ and this adds another layer to the puzzle: will firms pass on the rises in marginal cost to consumers or partly absorb them?

What about unemployment?

In the first months of the crisis, the demand shock seemed the most pressing. In the UK, the government has been able to deal with the demand challenge very well. In particular, the job furlough scheme, at first a six-month policy, was extended until September 2021. This supported the pay of eight million people at its peak during the first lockdown and has helped a further four million people since then. By protecting people’s incomes, this scheme reduced the increase in unemployment considerably.

UK unemployment is currently approximately 5% (or 1.8 million people). Without the furlough scheme, the level of unemployment might have been two or even three times higher, causing a very strong contraction in demand (as people who become unemployed cut their expenditure). As a result, the government intervention seems to have reduced the relative importance of the demand shock. But unemployment looks set to remain above its pre-pandemic level (around 4%) for the next couple of years, and this could lead to wages being stagnant, again hampering consumer demand (as people will have less disposable income).

Saving versus spending

Another aspect of the demand shock is the huge increase in household savings. This is partly due to consumers being unable to spend and partly a reaction to uncertainty about the future.

Another source of uncertainty for forecasters is how far demand will recover and even surpass its previous levels. If the uncertainty remains, this may lead to people holding back consumption and building up their savings or paying back debt. On the other side, this ‘pent-up’ demand might lead people to spend large sums of money on things they haven’t be able to buy during lockdown.

Further, there are still many products and services on which it remains difficult to spend money. Some pubs, cafes and restaurants have gone out of business, and the venues that are re-opening cannot serve as many customers. This reduces the availability of bookings, making it harder for consumers to spend on a practical level.

An additional consideration is that over the last 20 years, economic analysis of consumption has found ‘habit persistence’ to be important: now people are used to spending less on certain things, they may be less interested in increasing their consumption to pre-pandemic levels, even if they can afford to do so. Also, some people have become used to working shorter hours and it may take them some time to be willing to work as long hours as they did before the pandemic.

How might the supply shock affect inflation?

Turning to the supply-side effects, it is likely that these will continue for some time. In the UK, supply-side effects have been worsened in some sectors by shortages of workers. Many European Union citizens working in the UK chose to leave and spend the pandemic at home. There are currently workforce gaps in several service sectors, which are likely to intensify as more of the economy opens up.

There is also Brexit. Supply shortages caused by pressures along supply chains are harder to predict. For the UK, these issues may be exacerbated by Brexit as firms adjust to the post-Brexit trade agreement.

Supply shortages are partly driven by world markets. Some commodity prices are increasing, including lumber, coffee, soybeans, cotton, copper and other metals. Some of this will be short-term, reflecting the events of the pandemic and its immediate aftermath. Others will be longer-term (for example, copper is used in a lot of alternative energy equipment and electronic vehicles). But in any case, commodity price inflation does not always feed through directly into consumer inflation. This is because commodities are only one part of the production, and overall value, of consumption goods.

Putting the parts together: what will happen in the next two years?

Should we expect more inflation in the coming years? The short answer is ‘yes’. It is worth noting that the UK is starting from a low level of inflation. The CPI started to fall below 2% in mid-2019 and has been less than 1% for most of 2020. It is reasonable to predict that the low inflation figures of 2020 will increase in 2021, raising inflation towards 2% and above.

The supply-side effects can be expected to raise inflation by an estimated 0.5%, according to a study by the Banque de France. Demand is harder to predict, but if consumer demand recovers to pre-pandemic levels (or exceeds them), this might then outstrip the ability of firms to supply the necessary goods and services required for an effective recovery, leading to limited additional inflation.

These factors together might be expected to take UK inflation into the 2-3% range. But even in normal times, a series of additional positive inflation shocks could then push inflation higher. Of course, the pandemic could cause further restrictions to economic activity if new variants of the virus emerge, and this could have a large effect on inflation.

But in the absence of these confounding factors, it seems unlikely that inflation will exceed 3% for a sustained period in the coming years (and highly unlikely it will exceed 5%). The fears of a return to 1970s or even 1980s levels of inflation experience appear unfounded.

What about government expenditure and the increased deficit?

Could the increased government deficit lead to a level of demand that the economy cannot keep up with, resulting in higher inflation? The short answer is ‘no, not if the high government expenditure is transitory’. The large government deficits of over 13% of GDP in 2020 and 10% in 2021 reflect the direct impact of the pandemic on reducing tax revenues (as output and employment fell) as well as the policies taken to counteract the demand shock (such as the furlough scheme).

The International Monetary Fund (IMF) Fiscal Monitor 2021 makes the following predictions for the UK government deficit as a % of GDP over the years 2020-25.

Table 1: IMF Fiscal Monitor: projected UK government deficit

UK Fiscal Balance as % of GDP (IMF)

Source: International Monetary Fund

The UK government has stepped in to counteract the fall in household consumption and firm investment, mirroring the increase in household savings. The level of the deficit will fall rapidly once the government reduces this intervention – simply ending the furlough scheme and related job support policies will reduce the deficit to GDP ratio by about 5%.

If household consumption remains weak, there is an argument for tapering off the fall in government expenditure more slowly in 2022 and beyond. If there is a post-pandemic boom in consumption and investment as some predict, then government expenditure should be reduced more rapidly to avoid ‘overheating’ where an excessive government deficit would lead to a sustained excess of demand over supply.

Current forecasts suggest that output recovery from the pandemic will be sluggish and the UK will not regain the pre-pandemic level of GDP before 2022, possibly later. This would suggest that the government can slowly reduce its deficit over the next 18 months until it is back to its more usual levels below 3% of GDP in 2024. So long as the government avoids the trap of keeping expenditure high when private consumption is strong, the demand-side pull on inflation should not be present.

The government will thus face a difficult balancing act on the fiscal side in the coming months. The challenge is that the real-time economic data on GDP are often unreliable, and fiscal policy takes time to design and implement. In the past, it has been all too easy for the government to overshoot or undershoot on the fiscal side and this can affect inflation as we go forward.

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Author: Huw Dixon
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