Sticky inflation

UK inflation has been largely stoked by two main drivers – a US-style labour supply squeeze and a euro area-style energy and food price shock. This has contributed to a stickier than expected outcome. Once described as ‘transitory’, dealing with inflation in this cycle has proven more of a challenge, particularly for the Bank of England (BoE). 

Be wary - inflation and monetary policy elevate the risk of recession

Even with record pay increases, real incomes are still on course to drop and that presents a danger of triggering a recession. The recovery from a two-month downturn in early 2020 has endured one of the most aggressive interest rate-hiking cycles in history. The UK economy has, however, been surprisingly resilient. Strengthening services inflation has driven core inflation in the UK to more than 30-year highs.

The BoE has had less success in taming price pressures to date than its American (The Federal Reserve) and European (European Central Bank) counterparts. UK monetary policy mainly targets the housing market by making borrowing more expensive, thus reducing the overall amount of household disposable income available to spend in the wider economy. However, this channel is less effective than in the past and will have longer lags largely due to most mortgage debt now being in fixed-term agreements. The more immediate impact is on unsecured lending (e.g. credit cards) that has been readily accessible for a number of years when the cost of borrowing was at record lows. Monetary tightening is already, albeit gradually, squeezing real incomes. 

Although disruptions to global supply chains have now started abating, the supply of UK labour remains restricted. For example, the inactivity rate, which measures the portion of working age people that are not in the labour force, jumped 1.5 percentage points between February 2020 and July 2022, driven by a rise in long-term sickness, as well as increased numbers of people opting to study or retire. The inactivity rate has fallen back in recent months but remains around a percentage point above its pre-Covid level. This lower supply of labour is contributing to the tight labour market and high wage growth we are witnessing today.

In early 2022, when UK consumer price inflation (CPI) was already above 6%, the UK was hit by a large energy and food price shock as Russia invaded Ukraine. The energy shock was larger in the UK than in the euro area. Governments on the continent capped prices sooner and at a lower level than in the UK and the latter’s regulatory price mechanism (the Ofgem price cap) means prices are slower to fall back too. This further pushed UK inflation to a peak above 10% though the headline is past its peak now.

Today, there is roughly an equal (and large) contribution to UK inflation from all four major components (energy, food, core goods and core services). In the US, core services dominate, whilst in the euro area energy prices did most of the work of driving inflation before being replaced by food. The UK has the worst of both worlds, and as such, a higher and more sticky inflation has been the result.

Core Inflation

This excludes energy and food prices and has accelerated, with a tight labour market and strong private-sector wage growth adding to concerns. This contrasts with the US and euro area experience, where the disinflationary process appears well under way and core inflation seems to have peaked earlier.

Financial markets largely agree with this view

Two-year UK government bond (gilts) yields are trading above 5%, exceeding the level reached during the UK’s ‘mini budget’ last autumn. Mortgage rates have since soared, however, the market’s once expectation of a peak rate north of 6% seems excessive but the base rate could still peak at 5.5-5.75% and stay there until at least mid-2024.

There are, however, tentative signs that the tightness in the labour market is easing. Job vacancies, although elevated, have recently fallen, and job-to-job flows are softening. A recovery in labour force participation is also encouraging.

Persistent inflation is a worldwide challenge

Developed market economies have overall, proved fairly resilient in the face of persistent inflation, tight labour markets and rising monetary policy interest rates. Central banks have needed to raise monetary policy rates higher than initially anticipated and the last leg of inflation reduction to target levels may be the most challenging e.g. the BoE’s target is 2%. That last leg is also likely to vary by region.

The initial catalysts for the surge in inflation were global in nature, and the pace at which inflation travels down that last mile to the target level will depend more heavily on local drivers, how restrictive policy tightening is in each country or region, as well as local demand, labour market and housing dynamics.

Central banks may have to keep interest rates in restrictive territory for longer as the fight against inflation continues. And with that, further economic weakness can be expected in the months ahead.