December 22nd: most of UK inflation is imported

I find this data, from the ONS, useful for grounding the debates about UK inflation. It shows a breakdown of the annual inflation recorded in any month into the goods and services, categorised by their import intensity. It’s a useful reminder that we live in a globalised economy where UK’s inflation is highly dependent on both exchange rates and price dynamics in other countries.

Even in November, when CPI inflation spiked up to 5.1% (only slightly lower than its previous 2 spikes in 2011 and 2008), the vast majority of the price increases recorded were due to goods and services that are relatively import intensive. A rough weighted average across all the categories would indicate that around half of the inflation in November was due to imported products and services.

Of course, in reality, that’s not quite how markets work. Even the possibility of importing (or exporting) a product means that its prices will be coupled to those in other countries. Why is this? It’s explained by a key concept in economics called the law of one price. This principle that states that the price of an identical asset or commodity will have the same price globally [adjusted for transportation costs], regardless of location, if it could be shipped from one place to another.

So, let’s take, for example, beer, spirits and wine, which are in the lowest import intensity category in the chart (0–10% of household consumption is imported directly or indirectly). Let’s also say that the cost of these goods goes up significantly on the European continent, for whatever reason. For the sake of the example, let’s pick a reason that might impact continental producers while not impacting UK producers. Perhaps their labour force is more unionised and is able to negotiate a significant increase in compensation, pushing up producers’ costs and therefore prices. Why should this have any impact on UK prices, especially if so little of the UK’s drinks are imported?

I’m going to assume that alcoholic drinks produced in the UK and on the continent are relatively substitutable (i.e., any consumers in both locations that previously preferred a local brand will nevertheless buy a foreign brand if it’s much cheaper). If prices of locally produced drinks on the continent go up substantially, there will be a market opportunity for UK producers to sell more of their (lower-cost) products abroad. Logically, the price at which the same producers will be willing to sell in the UK cannot be much lower than the price they can fetch for their drinks on the continent (minus tranportation costs).

The bottom line is that not much product needs to actually flow across borders for prices to stay coupled. It is the threat or opportunity of increased trade that keeps prices similar. On this basis, it’s fair to say that UK inflation in almost all of the import intensity categories is significantly impacted by global prices. [I say “almost” because for some services, such as hospitality or personal grooming, while the arbitrage rule still holds, the transportation costs — in this case of shipping people to enjoy their meals and drinks, or haircuts, in, say, Calais, starts to be prohibitive.]

Even if we focus just on the higher import intensity categories, it’s clear that to date, the majority of the increase in inflation has come from these types of goods and services. In the graph, only around 2% of the 5% was attributable to things that were in the two lowest import-intensity categories.