The two things are, of course, related, and it is a long time since inflation was this high. Consumer price inflation is already at its highest since March 1992 and, if the OBR is right, will soon be the highest on record. The consumer prices index only goes back to the start of 1989 and peak inflation, achieved in both April and June 1991, was 8.4%.
In practice, of course, inflation has been above this in the more distant past and, realistically, the rate looks to be heading for its highest in 40 years, since the early 1980s. America, where inflation has already risen to 7.9%, is ahead of the UK in having achieved a 40-year high even before the effects of the Russian invasion of Ukraine on energy prices.
People and businesses are not used to inflation being at these levels, nudging 10%. They would be in for an even bigger shock if interest rates were to rise to match the surge in prices. That seems unlikely, the Bank of England and other central banks apparently taking the view that most of the inflation spike is due to factors outside their control, as will be its subsequent fall, should it occur.
Bank Rate, which has been a narrow range of 0.1% to 0.75% (where it is now) since early 2009, should break out of that range in coming months, though markets think only to a peak of 2% or so, not 5% or 10%. It is not that long since the Bank was adding negative interest rates to its toolkit. They seem set to gather dust there for quite a long time.
Even if rates stay low, high inflation is a shock. Some of that is not bad news. People have got used to modest pay rises, in a way that they were not 30 or 40 years ago. This means that they do not expect employers to match high inflation with big pay increases. For most, that will mean taking the cost-of-living crisis on the chin. This works, of course, for only as long as medium-term inflation expectations remain low. Were those expectations to move up in line with this year’s inflation, not only would the Bank have kittens but we would be in different territory.
As it is, high inflation will act as a tax, reducing consumer spending. The assumption of most forecasters is that, in spite of the most intense squeeze on real household disposable incomes in many decades, a strong labour market and up to £200 billion of “involuntary” savings left over from the pandemic, so called because people could not spend on the things they usually spend on, will maintain spending, albeit at a lower rate than was expected a few weeks ago. Those two factors are having to do quite a lot of work in preventing a consumer recession.
The same is true of business investment. Alan Greenspan’s definition of stable prices, an inflation rate low enough so that it did not impact on the decisions of households and businesses, will clearly not apply this year. Will businesses spend more of their time responding to high inflation rather than investing for the future? It is a good question.
For what it is worth, the OBR predicts that consumer spending will rise by 5.4% this year and business investment by 10.6%, the latter boosted by the chancellor’s 130% super-deduction against corporation tax. We shall see. They are forecasts that civil servants might describe as “brave”.
What about the banking system? The Bank’s most recent set of solvency stress tests, published in December, tested the resilience of the banks in what it described as a “very severe” macroeconomic scenario, representing an “intensification” of the shocks the economy experienced in 2020.
Look through that scenario, however, and you will not find much, if any, mention of inflation. It included a further 9% GDP drop in 2021 and a cumulative GDP shortfall over the period 2020-22 of 37% relative to the pre-Covid baseline. There would be price falls, of 33% in both residential and commercial property prices, and a sharp rise in unemployment, to nearly 12% of the workforce.
That is an extreme set of events which, in the case of 2021, clearly did not come about. What the Bank did not test was an inflationary, or stagflationary, shock. And, just as people and businesses are unprepared for that, so there are very few people working in finance and banking who have professional experience of serious inflationary episodes.
Like the Bank and other central banks, they will be hoping that this is just temporary, and followed by a speedy return to a world they are accustomed to. It is the best that we can hope for at this time of uncertainty.