Britain’s double-digit inflation problem

Britain’s economy has been unique for a number of reasons recently. The IMF expects UK growth to be the worst among large economies this year. It has also suffered the biggest decline in workforce participation of any G7 nation since the pandemic began. Another unwanted distinction is the persistence of its inflation, which has now been in double digits for seven straight months. Price growth is lower and tumbling faster in continental Europe and the US. The ongoing cost of living crisis is troubling for Prime Minister Rishi Sunak who promised to halve inflation by the end of the year and is grappling with striking public sector workers demanding higher pay. Yet although British inflation stands out, there are grounds to believe it will converge with its peers soon.

In March, UK inflation dropped by less than expected, to 10.1 per cent. It has fallen by only 1 percentage point since its peak in October. In comparison, annual price growth in the eurozone is 6.9 per cent, and 5 per cent in the US; both are much lower than their peaks. Global price pressures have fallen. European natural gas prices have dropped sharply, supply chain disruptions have eased, and rapid rate increases by central banks are gradually squeezing demand. The extra stickiness in UK inflation, however, is linked to a few factors.

Energy prices have been the driving force behind European inflation since Russia’s invasion of Ukraine last February. The plunge in wholesale natural gas prices, and thus the decline in inflation, is filtering through faster in some EU countries compared with the UK. This is in part due to differences in how consumer energy prices are set. Britain’s energy prices will nonetheless fall quickly in the coming months. Statistical effects also mean the jump in energy prices last year will drop out of the year-on-year comparison, helping inflation to fall significantly.

The cost of food in the UK has soared too. In March, prices for bread and cereal pushed food price inflation to a 45-year high. The cost of ingredients and transportation has risen globally since the Ukraine war. Labour shortages, the weakness of sterling and poor harvests in Britain’s supplier countries have compounded the picture. Nonetheless, food prices are rising at similar rates in the EU. Looking ahead, pressures across global food supply chains are easing — the price of many agricultural commodities peaked last year and energy costs are reducing — which should filter through to supermarket shelves.

This makes the outlook for core price growth — which excludes energy and food — crucial to assessing inflation’s staying power in the UK. Britain’s underlying inflation is higher than in many advanced economies. That is in part down to a unique set of factors causing labour shortages, including early retirement, sickness and a change in immigration rules post-Brexit. This has kept wages higher in Britain. Although recent data suggests the jobs market is showing signs of cooling, with hiring plans falling and wage growth edging down, it has not weakened as quickly as the Bank of England would have hoped. Businesses still have high pricing expectations for the year ahead, in part due to higher wage costs.

Prior interest rate increases will increasingly filter through, weigh down demand, raise unemployment, and ease price pressures. But with core inflation at more than triple the BoE’s inflation target, policymakers still need to ensure domestic price pressures turn a corner. This means that a further 25 basis point rate increase at next month’s monetary policy committee meeting looks sensible. The easing of global price pressures should mean that headline inflation in the UK will subside to single digits. But the BoE still needs to finish the job on curbing price pressures at home.

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