Inflation has risen sharply this year, driven in part by price rises in products like cars, chips and furniture, plus disruption to the supply chain. Some experts think this could signal forthcoming economic instability, whereas others say that a current spike in inflation will be temporary and can be explained by the economy bouncing back.
Spike in Inflation Will be Temporary
The rate of inflation increased from 1.5% to 2.1% in May, which is the highest it has been for nearly two years. So consumers are currently paying higher prices for new and used cars, consumer electronics, computer chips, furniture, appliances and sports equipment. According to the BBC “Some firms are struggling to secure summer items like garden furniture, picnic baskets and outdoor toys, as consumers prepare to holiday in the UK.” Lockdown dramatically changed many people’s spending habits. However it’s not yet clear whether this spike in inflation is part of a permanent, new trend in spending being ushered in, or a temporary disruption emerging now in relation to changes in spending behaviour during lockdown phases. After all, we haven’t had much chance to buy concert tickets, go on holiday, or even pay for as many train tickets travelling to work, over the last year. Instead we have collectively spent a lot more on groceries and online streaming subscriptions as evidenced in alterations to the Office of National Statistics (ONS) “basket of goods”.
What is Important about the Rate of Inflation?
Inflation is the rate at which prices for goods and services are rising. You may not notice low levels of inflation from month to month, but in the long term, these price rises can have a big impact on how much you can buy with your money. If a spike in inflation appears to be rising too sharply, it’s seen as a sign that the economy is unstable, whereby demand outstrips supply, destabilising prices . This is why, if inflation rises too quickly, the Bank of England (BoE) will often tackle it by raising interest rates. Before the pandemic hit, UK inflation was around 2%, which is the BoE’s ideal rate, which it aims to maintain. Some experts say that this spike in inflation could be a warning sign that the economy is running into trouble, while others say it’s a result of the economy starting to grow again, possibly more rapidly than predicted. The forecast is disrupted further, by enormous government spending on business support packages that protected the economy. Companies have borrowed more than £70 billion in government backed lending, which has allowed businesses to survive financial chaos caused by Covid-19.
New Trends Reflected in Consumer Price Index
Analysts are monitoring closely our spending to evaluate this spike in inflation to filter out what adjustments in the Consumer Prices Index (CPI) indicate more permanent, incoming trends and what are short term influences on consumer behaviour. This year the ONS added hand sanitiser, smart watches and exercise equipment, to their ‘basket of goods’ – by which they measure prices and spending. The ONS monitors the prices of thousands of everyday items, from motor oil to cinema tickets. Known as the “basket of goods”, is a list of household goods, the prices of which are being constantly reviewed to indicate trends in spending and consumer behaviour. More weight is given to things we spend more money on – if the price of petrol rises by 1p, that will have a bigger impact on the headline inflation rate than, say, 1p on a book of second-class stamps. The ONS releases its measure of inflation each month – showing how much these prices have risen since the same date last year – known as the CPI. The inflation rate is used to inform a whole range of decisions, from how much pensions will rise to the price of train fares. It’s monitored keenly by economists, who see inflation as an indicator of what’s going on in the economy. Small amounts of inflation are natural and even helpful: it encourages people to keep spending, if they expect prices to rise in a few months’ time. And that’s good for business. The Bank of England aims to keep inflation hovering at around 2%. If interest rates rise, then the cost of mortgages, student loans, and other borrowing, all go up. This means that people and businesses will have less money to spend, which causes demand to fall. Last year’s low inflation may have been a false indication due to Covid, and this year’s much higher inflation could just be a correction. It will be several more months until we know this for definite. Analysts are predicting optimistically that this rise is a temporary spike in inflation and will reverse itself over time.
Early Warning Signs
In the UK, inflation rates have barely been above 4% for nearly a decade, so this latest spike in inflation is not necessarily a cause for alarm at only 2.1%, yet there is fierce debate among economists over whether higher inflation is in the pipeline. It’s possible that years of low inflation have made economists complacent. In the wake of the Covid-19 global pandemic follows a financial crisis in the making and a huge question is still how will the government manage the £300bn deficit? Covid-19 has caused a seismic economic shock and the aggregation of a staggering national debt to head off economic meltdown with a raft of support packages to support businesses that suffered throughout rolling lockdowns and sweeping changes to economic behaviour, could potentially lead to more risky levels of inflation. Others say there isn’t really any underlying cause for concern. Inflation was low before the pandemic and they don’t believe that will fundamentally change once life returns a bit more to normal. A 4% inflation rate would also be twice the Bank of England’s forecast. James Smith, research director at the Resolution Foundation, said the squeeze on real incomes would be ‘a significant threat to the strength of our current recovery’. ‘With the US experiencing the fastest rise in inflation in nearly half a century, and the UK also experiencing sharp increases, many people are getting increasingly worried about a possible price spiral,’ he said. ‘The temporary nature of this inflation spike means the Bank can look through it and avoid premature rate rises. However the Resolution Foundation predicts that inflation is on course to rise above four per cent in the coming months, which they calculate will reduce real, average household incomes by £700. And while monetary policy makers at the Bank of England should ‘look through’ this temporary inflation spike, fiscal policy makers should act to protect family incomes and strengthen the recovery. The Foundation’s latest Macroeconomic Policy Outlook explores mounting inflationary pressures in the UK, how they compare to the pressures in the US that are already sparking fierce debates, and how policy makers should respond to the prospect of above-target inflation.
Spike in Inflation Trending in the United States
Historically we have seen UK inflation rates trending close to US rates in recent decades. So experts argue that this indicates we should expect an incoming inflationary spiral in the UK. However, the short term inflationary pressures in the UK are less stark than the US so far. In the US inflation rose from 0.1% to 5% within a year between May 2020 and May 2021. This is the fastest rise in nearly half a century. This is the highest rate of inflation in the US since the financial crisis in 2008, mainly as a result of the world’s largest economy rebounding strongly from the coronavirus crisis. The cost of flights, household furnishings, new cars, rental cars and clothing all rose during May. However these increases can be explained by depressed prices a year ago, the semiconductor shortage that turbocharged used car prices. There is likely to be noise in the data for more months to come indicating a strongly rebounding economy rather than signaling the long-term trend for inflation. The Federal Reserve slowed their stimulus programme responding to fears over rising prices unsettling markets, fearing that a backlog of demand combined with supply chain bottlenecks would create unmanageable inflationary pressures. Yet US stocks rallied on the news as traders anticipated that the inflationary surge would be temporary, allowing the Fed to put off tapering a bond-buying policy that has pumped money into global markets.
UK Fiscal Plans to Avoid Inflation Spiral
Meanwhile the UK has experienced the sharpest spike in inflation in a single a six-month period, since the aftermath of the financial crisis in 2008. We suffered a bigger economic hit during the financial crisis, which means that our economy has more capacity to absorb, before we start to see sustained price pressures. And whereas the US is currently embarking on a major fiscal stimulus, the UK is about to start withdrawing support, including the ending of business rates relief and phasing out of the furlough scheme. While the UK is unlikely to experience the same inflation peaks seen in the US, if commodity prices remain at their current levels, it is still possible that UK inflation could rise above 4% later this year. This would be more than double the rate of inflation forecast by the Bank of England for the third quarter. The Resolution Foundation warns that this equates to a reduction of £700 to average, annual disposable household incomes by the start of 2022. These inflationary pressures present a challenge to fiscal policy makers in managing the current spike in inflation. The Resolution Foundation warns that the Government’s current plan to reduce Universal Credit by £20 a week in October risks being particularly damaging for the six million families affected by the cut, at a time when higher than expected inflation will, at least temporarily, be pushing down on household incomes. It urges the Government to reconsider its plans to cut support in order to strengthen the current economic recovery, which risks being undermined by squeezed household incomes. James Smith, Research Director at the Resolution Foundation, urged the Chancellor to reconsider the planned cut to universal credit. He said: “The temporary nature of this inflation spike means the Bank can look through it and avoid premature rate rises. But the £700 hit to living standards it will bring, means households and the Government cannot afford to ignore it. The Chancellor can start by cancelling the planned cut to Universal Credit this Autumn, which will only add to families’ financial pressures. A squeeze on household incomes later this year, even if temporary, is a significant threat to the strength of our current recovery.”
The Bank of England is watching movements in the prices of goods and services “extremely carefully” for signs that UK inflation is about to rise persistently above the central bank’s target, says governor Andrew Bailey. He told parliament that the BoE’s Monetary Policy Committee would not tolerate a persistent overshoot in inflation over its 2 per cent target, signalling it could raise interest rates in such a scenario, but he said he saw little evidence of this happening at present. BoE officials said current rises were anticipated and it would mostly return to normality following this spike in inflation, after the rate was artificially depressed by extremely low petrol and energy prices over the past year because of the coronavirus pandemic. “Our forecast at the moment is that we do expect inflation to pick up,” said Bailey, because there had been a “strong shift in energy prices”, but he expected any overshoot of the BoE’s 2 per cent target to be temporary. The BoE predicts inflation is likely to rise towards 2.5 per cent by the end of this year, but then drop back towards its target. “We see a bounce back in the economy, but we don’t see the momentum continuing forwards at that pace at all,” said Bailey, referring to expectations for high economic growth this year. “Fiscal policy is very supportive this year but actually starts to tail off next year.” Questioned over media stories about a surge in raw material costs, Bailey said the Monetary Policy Committee (MPC) would need to see the evidence unfold, but there was no sign yet that inflationary pressure was likely to become embedded in workers’ wage demands or persistently high price rises. “We do hear stories about input prices, but we are not yet seeing strong evidence of the pass through into consumer prices,” he added. “I can assure you we will be watching this extremely carefully and we will take action when we think it’s appropriate to do so, no question of that.” Bailey was speaking to the Lords committee as part of its inquiry into BoE’s quantitative easing programme, under which the central bank has created money to purchase government bonds, and the effects on the economy. Bailey said he thought QE had been effective during the Covid-19 pandemic in supporting the economy, but the programme was “more effective” at times of financial distress, such as in March last year, when it soothed emerging problems in credit supply to companies.
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