Everyone is talking about inflation and how the UK is battling to lower its inflation? I would like to understand this from a common man perspective and discuss how we reached here and when do we come out of this mess?
According to the Bank of England, Inflation is the term used to describe raising prices. How quickly the prices go up is called the rate of inflation. We know the rate of inflation because every month the Office for National Statistics checks the prices of a whole range of items in a ‘basket’ of goods and services.
They record the cost of over 700 things that people regularly buy. The basket includes everyday things like a loaf of bread and a bus ticket. It also includes much larger ones, like a car and a holiday.
The price of that basket tells us the overall price level. This is known as the Consumer Prices Index or CPI.
To calculate the rate of inflation, they compare the cost of the basket – the level of CPI – with what it was a year ago. The change in the price level over the year is the rate of inflation.
Is high inflation a problem?
A low and stable rate of inflation helps to create a healthy economy.
The Government sets a target for how much prices overall should go up each year in the UK. That target is 2%. It’s the Bank of England job to keep inflation at that target.
A little bit of inflation is helpful. But high and unstable rates of inflation can be harmful.
If prices are unpredictable, it is difficult for people to plan how much they can spend, save or invest.
In extreme cases, high and volatile inflation can cause an economy to collapse. Zimbabwe is a good example. It experienced this in 2007-2009 when the price level increased by around 80 billion per cent in a single month.
As a result, people simply refused to use Zimbabwean banknotes and the economy ground to a halt.
So what exactly has happened in the UK and why is the inflation so high compared to the other G7 nations?
Inflation in the UK is being driven by Brexit, Covid-19, Russia's invasion of Ukraine, and supply chain-related issues. These shortages are driving prices higher, making the cost of living more expensive.
Inflation in the UK is being driven by 4 main factors,
1. Brexit
Britain is a highly open economy with total trade equivalent to 60% of GDP. What is GDP?
Gross domestic product or GDP is a measure of the size and health of a country’s economy over a period of time (usually one quarter or one year). It is also used to compare the size of different economies at a different point in time.
To measure GDP each quarter, the Office for National Statistics (ONS) collects data from thousands of UK companies. And to complicate matters, there are three ways to measure GDP! You can calculate it by adding up, for everyone in the country:
The total value of goods and services (‘output’) produced;
Everyone’s income;
Or what everyone in the country has spent.
The UK’s manufacturing base is also smaller than countries such as Germany and Italy. However, companies in Britain face additional costs from Brexit, with reams of paperwork and border delays adding to the pressure.
The pound has remained weak against the dollar since the EU referendum in 2016
The EU accounts for about half of total imports. Though just under half of food consumed in Britain is produced domestically, including the majority of grains, meat, dairy, and eggs, much comes from the EU.
The thinktank UK in a Changing Europe estimated post-Brexit trade barriers pushed up food prices by 6% between December 2019 and September 2021.
Worker shortages
Fewer foreign workers are seeking jobs in the UK after Brexit, while many older people left the workforce during the pandemic. Labour shortages are leading companies to increase pay, adding to their wage bills, and leading them to raise the prices they charge for goods and services.
Unemployment has fallen to the lowest level since the mid-1970s, with the number of people out of work below the number of vacancies for the first time ever. Annual average pay growth, excluding bonuses, has risen to 4.2%, among the fastest rates for a decade.
2. Covid-19
The COVID-19 pandemic prompted a historic shock to the UK economy, as measured by its gross domestic product (GDP).
Between April and June 2020, the height of the first national lockdown, GDP fell by a record 19.4% before rebounding 17.6% as the country reopened over the summer. The magnitude of the recession caused by the pandemic is unprecedented in modern times. GDP declined by 9.7% in 2020, the steepest drop since consistent records began in 1948 and equal to the decline in 1921 on unofficial estimates.
During the first lockdown, UK GDP was 25% lower in April 2020 than it was only two months earlier in February. Economic activity picked up over the spring and summer of 2020, reflecting the opening up of the economy. This was followed by a rise in Covid-19 cases and further lockdowns during the autumn and winter, leading to economic activity falling again.
The decline was, however, much less severe than during the first lockdown, as consumers and businesses had adapted over the previous year. A strong recovery in spring 2021 led to a rebound in GDP, although growth slowed in the summer and autumn. As of October 2021, GDP was still 0.5% lower than before the pandemic.
3. Russia’s invasion of Ukraine
The invasion began on the morning of 24 February, when Russian president Vladimir Putin announced a "special military operation" aiming for the "demilitarisation" and "denazification" of Ukraine.
Britain is a net importer of energy, meaning it is exposed to global price shocks. The post-lockdown surge in oil and gas prices, exacerbated by Russia’s war in Ukraine, is no exception. However, some other countries have done more in response.
France has a 4% cap on electricity price rises, helped by state ownership of the energy producer EDF. The country also sources the majority of its energy needs from nuclear.
Italy has a windfall tax on energy firms and is spending €8bn (£6.8bn) to shield consumers from higher bills. Spain and Portugal are capping gas prices after winning approval from the EU. Germany has cut fuel tax by 30 cents a litre, compared with a Britain’s 5p cut. Ireland has cut public transport fares by 20%, while Spain and Belgium have cut VAT on energy bills – something Boris Johnson claimed could be done after Brexit, but has failed to enacted.
The UK government has announced £22bn of support for high energy costs for the current financial year, including cuts to fuel duty, a council tax rebate and repayable loans on energy bills. The measures do not, however, influence the headline inflation rate.
4. Supply chain related issues.
Disruption from the pandemic, along with China’s “zero Covid” policy, has pushed up freight prices and caused costly delays. However, companies in Britain face additional costs from Brexit, with reams of paperwork and border delays adding to the pressure.
So what are the steps from the UK govt with support from the Bank of England to keep the inflation stable?
It's the Bank of England's job to keep inflation low and stable.
The main way Bank of England do that is through interest rates. An interest rate is the amount of money people get on any savings they have. It’s also the charge they need to pay on their loans and mortgages.
So what’s the link between the interest rates and inflation?
Higher interest rates make it more expensive for people to borrow money and encourage them to save. That means that overall, they will tend to spend less.
If, people on the whole, spend less on goods and services, prices will tend to rise more slowly. That lowers the rate of inflation.
The opposite is also true.
Lower interest rates mean it’s cheaper to borrow money, and there’s less of an incentive to save. This encourages people to spend and increases the rate of inflation.
How does the Bank of England influence interest rates?
Bank of England can influence interest rates in two main ways.
One - Bank of England set Bank Rate, often referred to as the base rate. This is the single most important interest rate in the UK because it influences all other interest rates.
Two - Bank of England can buy and sell bonds from financial markets to support spending in the economy. Bank of England mainly buy government bonds, or ‘gilts’.
Why is inflation expected to fall from the middle of 2023?
Here are few reasons why Bank of England expect inflation in the UK to fall sharply from the middle of next year.
First, the price of energy won’t continue to rise so quickly. The Government has introduced a scheme that caps energy bills for households and businesses for six months.
Second, Bank of England don’t expect the price of imported goods to rise so fast. That’s because some of the production difficulties businesses have faced are starting to ease.
Third, Bank of England expect there to be less demand for goods and services in the UK. That should mean the price of many things will not rise as quickly as they have done.
These are interesting times. Let's hope the UK's strategy is successful and the economy recovers soon.
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