The biggest concern, however, for the markets, was the news from the Office for National Statistics that, “Core CPI (excluding energy, food, alcohol and tobacco) rose by 6.8% in the 12 months to April 2023, up from 6.2% in March, which is the highest rate since March 1992; the CPI goods annual rate eased from 12.8% to 10.0%, while the CPI services annual rate rose from 6.6% to 6.9%.”
Policy rates expected to peak higher
The persistence of core inflation led markets to raise their expectation of where policy rates will peak. At their recent Monetary Policy Committee, the Bank of England raised the policy rate by 0.25% to 4.5% and their message reaffirmed the market’s belief that rates would head higher.
The market at that time factored in policy rates rising to at least 4.75%, and had not ruled out that they might peak at 5%. Now, following the latest inflation data, the market expects policy rates to peak around 5.5%. In turn, bond yields rose significantly, and are not far below the level they reached in the aftermath of the mini-Budget.
The similarity between both occasions, last autumn and now, is the market’s concern on both inflation and their lack of confidence in the UK’s anti-inflationary policy stance.
Understanding why inflation is so high
It’s vital to understand why inflation is so high. In 2020 the annual rate of UK inflation dipped to 0.2% in August, and again to 0.3% in November that year. It was a time of considerable uncertainty as the pandemic hit. In early 2021, UK inflation again dipped to 0.4% in February but at that time it seemed clear that inflation was set to rise, coinciding with the further opening of the economy. In May 2021 inflation reached 2.1%, breaching the 2% inflation target, before heading higher.
The surge in inflation we have seen has been triggered by two factors: supply-side factors linked to the pandemic and then exacerbated by the war in Ukraine, and inappropriate monetary policy.
When I testified recently before the Treasury Select Committee to talk about quantitative easing (QE), I described QE and, in turn, monetary policy as the good, the bad and the unnecessary.
The good was the monetary policy response in the aftermath of the 2008 global financial crisis, when monetary policy easing alongside fiscal stimulus prevented a depression. The unnecessary was the prolonged period of cheap money for much of the last decade, which fed many economic and financial problems from which we are now suffering, not least inflation itself. Meanwhile, the bad was the Bank’s response to the pandemic and the monetary policy easing that followed.
Admittedly, one should not be too critical of the immediate response when the pandemic hit; after all, it was a period of extreme uncertainty. But as time progressed it became clear that it was a major supply-side shock and also that fiscal policy was being eased considerably. In those circumstances, it quickly became clear that monetary policy should have been tightened, not loosened. Monetary easing exacerbated the inflation shock.
Now, both factors that led to the surge in inflation over the last two years have been reversed. This includes a significant tightening in monetary policy. Thus, inflation is decelerating. Importantly, neither excess demand nor higher wages triggered this inflation shock.
Predicting the inflation dynamics is difficult
But once inflation rises, the inflation dynamics can change, and this becomes hard to predict. After a prolonged period of low and stable inflation, both in the UK and globally, a rise in inflation can have profound implications, particularly in an economy like the UK where in the wake of the global financial crisis, wage growth as well as productivity and overall economic growth has been low.
Thus, attention is on second-round effects, including the extent to which costs rise, such as wages, and whether firms raise prices to maintain or to boost margins. This is linked to wider economic conditions, including the tightness or otherwise of the labour market, and the overall state of the economy including people’s ability to pay higher prices, and thus demand conditions. Expectations, too, can impact such behaviours.
But as I have highlighted previously, when we have seen a change in the inflation climate before in the UK, economists and the market can be slow to adjust their thinking. In the early 1970s for example, there was an expectation that the surge in inflation would not persist and that inflation would return to its previous lows. It didn’t. It became embedded. Likewise, in the early 1990s.
Then I was in a small group of economists who thought we were moving to a new low inflation environment, but as inflation decelerated the market believed inflation would return to its previous higher rate. It took a while for expectations to adjust fully to the new, low inflation regime. There is a similar danger now. There has been a general expectation among economists and in the market that inflation will decelerate to 2%.
We have expected inflation to decelerate over the next year, possibly undershooting in a year the rate at which it might then settle, say 3% to 4% as opposed to the 1% to 2% we saw pre-pandemic. This, though, is above the 2% target.
The challenge raised by the latest inflation news is how serious is the Bank about achieving its inflation target. The US Federal Reserve has a dual mandate: low inflation and stable employment conditions. More recently, the importance of ensuring financial stability in the wake of the US banking crisis has also come to the fore in impacting monetary policy decisions.
In contrast, the Bank of England has a sole mandate: a 2% inflation target. It is this that is at the heart of the market’s latest thinking on policy rates. The belief is that if the Bank is committed to its 2% target, then it will need to tighten more.
A failure of modelling by the Bank
This week the Governor indicated that the Bank’s model had proved a poor predictor of inflation. Perhaps this is not a surprise, given the prolonged period of low and stable inflation. The Bank’s quarterly Monetary Policy Report (previously called the Inflation Report) never mentions monetary growth and also fails to differentiate, it seems, between monetary and fiscal policy, with a focus on aggregate demand.
Even if one is not a monetarist it is advisable to keep monetary aggregates on the dashboard of economic indicators.
Monetary growth peaked two years ago, and is growing around 4%, and would suggest no need to tighten further. Indeed, there is considerable monetary tightening in the pipeline. Part of the current challenge is the pressure on central banks to respond to the latest inflation news, even though monetary policy tightening acts with a long and variable lag. We would often think of this in terms of 12 to 18 months.
However, given the acknowledgement that their modelling is poor, perhaps it may be appropriate to assume that the Bank will continue to tighten until core inflation has been seen to have peaked.
Why is inflation so stubborn?
So if the two main factors that led to the surge in inflation are being reversed, why then is inflation still so stubborn? Energy prices were expected to persist at higher levels for longer than in other countries because of the way the UK calculates its energy price cap. Now, energy prices are falling.
Food price inflation has been persistently high. Previous bouts of food price inflation, here or elsewhere, suggest a strong link with energy prices, which are a key cost in the food production cycle. Food prices rose by an annual rate of 19.1% in the latest data. High food price inflation is a common problem, particularly across western Europe.
The cumulative increase in CPI food prices from December 2019 to April 2023 for instance was 26.3% for the UK, compared with 22.0% for Italy, 22.8% in France and 33.0% in Germany. For the euro area the rise was 26.7% and in the EU27 it was 30.4%. One would expect food price inflation to decelerate.
From February 2021 to April 2023 there has been a 19.5% increase in the UK price level. So, even though inflation is now decelerating, prices are considerably higher than before, eating into spending power.
Second-round effects raise the inflation risk
The latest UK news vindicates our view that inflation would persist. It has done so. Headline inflation looks set to fall, as supply-side pressures have unwound and monetary policy has been tightened considerably. High food price inflation partly reflects supply-side pressures and high energy prices. But energy prices are now easing. Food price inflation is likely to decelerate.
Second-round effects raise the risk that core inflation may be stickier, and it is this that the market is now reflecting. As the Bank is not seen as being on top of inflation, the market now fears they will have to hike further. While it takes time for previous tightening to feed through, there is now the risk the Bank will feel obliged to hike until core inflation is seen to have peaked and turned lower.
But the ability of firms to pass on higher prices will depend, in turn, on people’s ability to pay, so hiking rates to slow the economy is part of the transmission mechanism.
The UK economy faces conflicting pressures. Three stand out.
- One, it has defied expectations and avoided recession in the last six months and is expected to benefit from lower inflation, which boosts spending power.
- Two, against that, policy tightening will slow growth.
- Three, is the external environment, which points to a slowing world economy, with a soft landing in the US, a two-speed Chinese economy and a recession in Germany, all of which should ease external inflation pressures.
The end of cheap money remains the key issue impacting economies and markets.
Please note, the value of your investments can go down as well as up.
