UK inflation is rising at its fastest rate in four decades and could go even higher. The surge in inflation to a 40-year high of 9% in April and possibly to more than 10% later this year – as the projections in the ICAEW graph show – has inevitably invited comparisons to the extraordinarily high inflation experienced during the 1970s and 1980s. However, ICAEW’s chart also shows us that the current burst of inflation has more in common with the post-Second World War spike in inflation, when it peaked at 12%, than with the 1970s.
Before we examine the causes of today’s inflation, it’s useful to look back at historical bouts of high inflation and their causes.
The first real inflation spike charted on the ICAEW graph is in the early 1950s. As countries demobilised after the Second World War, this period was characterised by a surge in consumer demand that came up against supply constraints caused by the devastation of the war. As a result, inflation had jumped to 12% by 1952, as shown in the ICAEW graph. By 1955, however, inflation had dropped back to 1% as supply rebounded and consumer demand returned to normal.
Contrast this to the experience of the 1970s, when a huge oil price shock was exacerbated by a rigid labour market and monetary policy errors that caused inflation to reach 24%. It remained elevated for another decade, as the graph shows.
The two main perpetrators of inflation
The current surge in inflation is the work of two main culprits. The first is the pandemic, which dramatically increased demand for goods across the developed world. At the same time, it shut down factories and ports, creating havoc along finely tuned global supply chains. The inevitable result was a sizable increase in the prices of affected goods. For example, a shortage of microchips crimped the production of new cars, causing the price of used vehicles to rise by 27% y/y in April.
Second, the war in Ukraine has caused marked increases in the prices of many commodities, from energy to agricultural goods and metals. The price of natural gas in the UK, for example, is more than three times its level of a year ago.
Putting all this together, the Bank of England (BoE) estimates that around 80% of inflation is due to global shortages and the jump in prices of goods set on global markets, such as oil. That means that domestic forces, including demand for UK goods and services, are driving only 20% of inflation.
It seems to us that the current bout of inflation has less in common with what happened in the 1970s than it does with the post-Second World War experience of inflation caused by disrupted supply chains and a rebound in consumer demand after a period of depressed consumer spending.
Indeed, when compared with the 1970s, today’s UK labour market is much more flexible and unions have significantly less bargaining power. What’s more, the BoE is now independent and has already moved to tighten monetary policy. For that reason, we expect the current surge in inflation to be relatively short lived.
Admittedly, a further rise in Ofgem’s energy price cap in October will push inflation above 10%, and maybe as high as 11%. And high oil prices will ensure that inflation remains between 9% and 10% during the summer.
How will we ease inflation?
However, global goods price inflation should start to ease as supply chains normalise while disruption from the pandemic fades and consumers return to spending more of their income on services and less on goods.
A simultaneous and substantial weakening in economic growth, and potentially a recession, would reduce demand and inflationary pressure. As a result, inflation is likely to drop sharply throughout 2023 and will probably be around 3% in late 2023. We think it will continue to fall in 2024 and there’s a chance it will drop below the BoE’s 2% target should energy or food prices fall back.
So, what should businesses – and more specifically accountancy firms – be doing to mitigate inflation and the wider economic headwinds?
Understandably, many businesses will be concerned about increases to their cost base and their ability to pass on a proportion, if not all, of those extra costs to their customers and clients. However, there is a strong argument to suggest that one of the best ways to protect a business against the worst impacts of inflation is to use this time to invest in infrastructure. Why? Any investment in productivity enhancing, and therefore efficiency improving processes is, the logic suggests, going to be beneficial for that firm’s overall competitiveness and output in an economic cycle when margins are squeezed.
The UK is, as an average, one of the least productive G7 economies, which suggests our alignment to a full employment model might not be reflective of the full benefits investment in technology and capital items can deliver.
Our business love-affair with short-term profit and stakeholder value over longer-term enhancements and business sustainability may hinder UK businesses in weathering the current economic cycle as well as others that invest in those productivity-enhancing items.
With the economic challenges affecting all businesses to a greater or lesser degree, the supply chain impact, the rising utility and fuel prices and the cost-of-living crisis beginning to bite many households, variability and heightened financial risk will inevitably be of concern.
Accountants are vital
With that in mind, the role accountants play is now more important than ever as business leaders need and expect robust and timely (if not real-time) financial information from which management can base their decision-making.
Financial modelling and forecasting and reforecasting targets and budgets, cashflow analysis and subsequent impact of expenditure changes are likely to be more regular requirements as the inflationary impacts on the economy and business continue to take hold during 2022.
Thomas Pugh is an economist and Simon Hart is lead international partner at RSM UK
Click here to watch the ICAEW graphic that takes 75 years of inflation into account.
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