UK consumer price inflation is running at close to double digit rates – the highest in 40 years and about seven percentage points above the Bank of England’s 2% inflation target. This phenomenon is consistent across most advanced economies and has had profound implications for businesses and households, as well as policymakers, including central banks. So what is driving high inflation rates in the UK?
Post-pandemic inflation spike was amplified by Russian invasion
Historical context matters when analysing economic statistics that capture rates of change. When the pandemic first struck, most prices fell as businesses were trying to get rid of stock because of the uncertainty about the duration of possible lockdowns. Once economies opened up, businesses put up their prices and inflation started to pick up, albeit temporarily.
However, other mainly supply-side factors prolonged the spike in inflation rates. First, the rotation of household demand from service to goods put unprecedented pressure on supply chains, making it harder to get the right products at the right place and time. Second, interruptions in economic activity (eg, due to newer emerging variants of COVID) led to erratic and difficult-to-predict signals from consumers, which confused producers. Third, sector-specific issues including the shortage in semiconductors reduced the supply of goods reliant on them, such as cars and consumer electronics.
The ‘game changer’ for inflation was the invasion of Russia into Ukraine, which led to a general pickup in the prices of precious metals, fertilisers and food. As a result, more than half of the headline consumer price index (CPI) inflation rate is being driven by electricity, food and fuel prices, which central bankers have little direct control and influence over.
Where does this leave businesses and what is the role of accountants?
There is a variety of actions businesses can take to mitigate the impact of inflationary pressures and protect margins, by focusing both on revenues and expenses.
On revenues, getting the price right is essential, particularly when costs are rising faster than expenses. To do this, businesses need to design an effective pricing strategy based on their customers’ willingness to pay. This requires careful thinking and analysis in which accountants can contribute.
On expenses, managing costs in the current environment is very important. At a basic level, this could involve hedging strategies to avoid cost swings and extending contracts or finding alternative suppliers where possible. Businesses could also consider evaluating whether unnecessary work has been eliminated by automation so that their people focus on more value-added activities. At the same time, managers can think about enhancing spending visibility and get a better oversight of where money is being spent and who it is being spent by.
The role of accountants and business advisors is therefore fundamental to understand the profit and loss dynamics of any business and educate internal stakeholders on how pricing impacts the business. Increasingly, this involves not just focusing on the present, but also the future. For example, one of the questions clients ask me is to give them an insight of how their cost base is likely to evolve in the future. Doing so requires a bespoke, analytical approach as headline inflation forecasts are not specific enough to capture the intricacies of complex businesses focused in a specific segment of the economy.
Most of my work, for example, involves using my Chartered Accountant qualification and my professional experience and training as a macro economist to forecast the cost base of complex organisations. I have found that humility and acknowledging the high level of uncertainty involved in these types of exercise (e.g. through scenario analysis) is important.
This brings me to my final point about the role of business advisors and accountants: communication. Sometimes price increases are inevitable and it is the role of accountants to transmit the sometimes tough messages about financial performance to management. Management’s role is, in turn, to communicate these messages to internal and external stakeholders, including clients.
Where do you think inflation is going to head?
In the short-term, inflation dynamics will be determined by developments primarily in the energy market. For our main scenario projections, we expect CPI to average around 9% this year, followed by around 6-7% next year. This assumes that energy prices broadly follow their future curves as determined by financial markets in July.
There is a high level of uncertainty about these projections due to mixed messaging about the flow of Russian natural gas to continental Europe during the autumn and winter months – with a drop in supply driving inflation even higher – as well as other technical reasons, including on how the Office for National Statistics will treat the autumn energy rebates to households in the inflation calculation, which could reduce the headline inflation rate, albeit temporarily.
But the more positive news is that the supply chain constraints seem to be abating. Businesses are hoarding less inventories compared with previous months, which means they feel more confident about supply chains responding to changes in demand. Surveys across most territories confirm this point.
Inflation will be a challenge for everyone
UK businesses have faced four main shocks in the past six years – Brexit, trade wars, the pandemic and now high inflation, which is likely to remain high in the next few quarters. The latter poses a challenge for businesses and accountants, with the latter responsible to communicate sometimes tough messages to management. In the UK, most of the shorter-term price dynamics will be driven by energy and food price developments and are likely to remain elevated for the next few quarters. The more encouraging news is that supply chain pressures seem to be abating and that there is limited evidence of an economy-wide wage-price spiral developing, at least for now.
For more on inflation watch the ICAEW graphic that takes 75 years of inflation into account.
Readers can also visit ICAEW’s Inflation hub for a closer look at the impact of inflation on people, businesses, accountancy and the wider economy.
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