Putting worries about UK inflation in perspective
The UK’s annual inflation rate in June 2021— the percentage increase in the price of a basket of goods and services since June 2020 — has been received with some trepidation. Having mostly oscillated between zero and 1.0% since the COVID-19 pandemic began, inflation rates above (the Bank of England’s target of) 2% in May and June 2021 have caught commentators’ attention. Indeed, the increase between March and June, by almost 2 percentage points, is sharp by historical standards. A similar increase was last recorded at the end of 2009, as the economy recovered from the previous crisis. However, at 2.5% the annual inflation rate remains extremely moderate compared to, say, rates averaging more than 10% in the 1970s.
Moreover, there are many reasons to believe that this price shock is going to be transitory, even if the Bank of England were not to tighten its monetary policy stance (and they probably will). I’m not going to go to all of the reasons here, but as I’ve mentioned elsewhere, I am not convinced that the consumer “splurge” that everyone is expecting is going to be as significant as thought*. I’m even less convinced that general price pressures will turn into a wage-price spiral — not least because the bargaining power of labour has (in my understanding) reduced significantly, labour markets may have “hidden slack” due to the furlough scheme, and (again, in my understanding) labour costs are not a large direct component of end-user prices (anymore).
[*See, e.g., 8 February 2021 here, suggesting that any “accidental savings” have accumulated mostly to people least likely to spend them; and here, suggesting that people made a lot of long-term durable purchases in 2020 so they are less likely to spend on big-ticket items in 2021, except for holidays, which are not exactly plain sailing at the moment. Finally, McKinsey’s consumer sentiment data suggests that a large proportion (24%) of the population remain wary of venturing out into crowded places; and almost 20% are waiting for the disease “not to be spreading anymore” before returning to out-of-home activities. With a quarter of a million new COVID cases in the last 7 days, we are clearly not there yet.]
Today’s chart (which you can find both at the top and bottom of this blog) is further evidence that domestic supply/demand conditions are unlikely to be at the core of the recent rises in inflation.
First, a major chunk of the increase is due to energy prices (black segment on the graph), which — as the saying goes — can go up as well as down. Having worked on energy and climate change for nearly 10 years earlier in my career, all I can say with certainty is that no-one has a crystal ball for forecasting energy prices. There are good reasons to think climate change mitigation could put some upward pressure on prices; but I don’t personally think that the impact on inflation will be material compared to typical fluctuations in global oil prices. [For example, crude oil prices have ranged from $17 to $74 since 2015; and have been even more volatile in the past.] In the longer term, once a significant proportion of the investments towards net zero have been become sunk cost, and as technology continues to reduce the cost of low-carbon energy, we could see deflationary impacts from energy prices.
Second, for the remainder of the inflation rise, that, too, has mainly been imported. Since March 2021, more than half (0.7 percentage points) of the 1.2 percentage point non-energy-related increase in inflation has come from goods and services that are import intensive (the dark blue and cyan blue segments of the graph). You may be wondering whether an import intensity of 25% (the lower end of the range for the dark blue segment) is that high, and mathematically, it probably isn’t. But looking at the types of products that fall into the 25–40% category (e.g., many food and drink items, clothing, and electrical appliances), I’m fairly confident that if their prices rise, it is mostly not due to purely domestic factors**. The fact that they could be traded more intensely will typically keep their prices in line with international prices.
[** The one exception to this is impact of changes in domestic taxation, such as VAT, which I have not looked into in any detail.]
Taking a weighted average of the increase in inflation from March to June (and giving “energy” a 100% import intensity, given that its price is determined on international markets) indicates that around 60% of the inflation was “externally generated”. Of course it is possible that those external factors continue to mount or are self-perpetuating — if, for example, higher prices were starting to feed into higher wages in labour-intesive goods in some other countries and if this became a broader global phenomenon. It is, indeed, likely that the UK will “import” some of the US’s much higher inflation through these international mechanisms.
But much will depend on the supply and demand balances in many other countries, too. And here, COVID-19 continues to be a major source of uncertainty and potential cause of a delayed global rebound.