The past 15 years have been a fascinating time to be an economist, watching as businesses and consumers have navigated a global financial crisis, significant shifts in global politics and the drivers of global growth, the UK’s exit from the EU, and a global pandemic. There has certainly been plenty to keep the economics’ profession busy as we try (and fail) to predict the future.
However, one constant (at least in the West) has been historically low levels of inflation. Once the bane of every UK chancellor, inflation has lain dormant under the control of an independent Bank of England (BoE) – until now.
Inflation reached 9% in the UK in April and the BoE now expects it to touch 11% come October. This is in stark contrast to April 2021, when inflation was 1.6% and the concern was deflation and the potential need for negative interest rates.
However, as the roll-out of vaccinations during the pandemic allowed the global economy to re-open, inflation began to pick up – reflecting pent-up demand meeting supply chain and labour market constraints, and driving up energy prices.
These constraints were initially seen as being ‘transitory’ in nature by central banks: factories that had been running at reduced capacity would quickly catch up, the labour market would cool as furlough came to an end and the increase in energy prices reflected a recovery from record lows.
However, these factors have endured, with the war in Ukraine adding to the pressure in supply chains, most obviously in energy markets. We are now in for a period of monetary tightening. The US Federal Bank has taken the lead, increasing rates by 0.75% on 15 June, followed by the less-hawkish BoE, which raised rates 0.25% – its fifth increase. The European Central Bank, meanwhile, has indicated that it will start raising rates in July.
It was inevitable
Inflation was perhaps always on the cards, given both the fiscal and monetary support provided to the global economy by governments and central banks during the pandemic. It’s clear now – from an inflation perspective – that some of this support could potentially have been withdrawn sooner.
But perhaps the most critical issue is that demand and supply imbalances in supply chains and labour markets are taking longer to normalise than expected. In some sectors, there are structural challenges that could take two to three years to resolve. The most obvious example of this is the shortage of computer chips in the automotive sector, which has seen lead times for new cars to extend to 12 months and increases of circa 25% in second-hand car prices.
While unemployment as a percentage has fallen In the UK labour market, there are half a million fewer people in work than before the pandemic – perhaps a legacy of lockdowns as people have re-assessed their priorities – while the so-called ‘Great Resignation’ is driving up salaries as companies compete for staff.
These are global issues – not dissimilar to the oil price shocks of the 1970s – and the UK is not alone in facing rising prices: inflation in the US was 8.6% in May and 8.1% across the Eurozone. However, Brexit hasn’t helped the UK’s position, as increased trade frictions and an end to free movement will drive up costs and ultimately prices.
Is a recession on the cards?
The expectation is that inflation will start falling away through 2023. This is partly mathematical as, for example, high energy prices pass through the Office for National Statistics calculations. However, the bigger driver is the expectation for slower growth: oil price shocks have historically preceded economic downturns and hence global growth is likely to slow in 2023, with a tail risk of a recession in the UK and US.
So, what should businesses do in response? Ultimately, higher costs will need to be passed through to consumers in the form of higher prices. Businesses need to be very close to their consumers, understanding how spending patterns are likely to change as consumer incomes are squeezed and prices rise.
We know that in downturns, all consumers (particularly the low paid, who are typically most affected) tend to cut back on discretionary spending and trade down to cheaper brands and goods. There may be some nuances this time around: post pandemic, consumers are more likely to be tired of staying at home, so spend on meals out, cinema trips, sports events and overseas holidays is likely to stay strong throughout the summer; spend on home entertainment – which held up during the pandemic – may well be affected.
The return of inflation is really just another consequence of the pandemic. While GDP in most developed markets has recovered to pre-pandemic levels, the true economic consequences of the pandemic and the impact it has had on government debt, working patterns, travel, education and more will take many years to properly play out. Rising inflation is one of the first of many long-term economic aftershocks from an unprecedented two years.
Peter Arnold is Chief Economist at EY UK
Click here to watch the ICAEW graphic that takes 75 years of inflation into account.
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