The return of inflation

Inflation in the UK is back. CPIH (the Bank of England’s new target, a measure of consumer prices which includes a measure of housing costs) rose by 2.3 per cent in the year to March, having been as low as 0.2 per cent just 18 months ago.

2.3 per cent was also the rate of increase in the year to February, but that pause in inflation’s rise looks to be a blip driven by the timing of Easter (which impacts considerably on flight costs). The upward ascent will likely continue in the months ahead.

Partially this reflects global factors. Inflation has been rising across the advanced economies in recent months. Commodity prices—especially oil—after a dramatic collapse in 2014-16 have rebounded, pushing headline inflation measures higher. The world economy seems to have a bit more spring in its step in general which tends to support higher inflation.

But alongside the global factors, the UK is experiencing some of the first direct economic impact of last June’s vote to leave the European Union. The large fall in the value of Sterling is pushing up the cost of imported goods as domestic suppliers react to the higher prices they now face. Input prices faced by UK producers are running at an annual rate of almost 20 per cent, a reflection of both the pound’s tumble and oil’s rise.

Where and when exactly inflation will peak is open to debate and much will depend on how the underlying economy—and in particular the labour market—performs. But inflation above 4 per cent within the next 12 to 18 months is no longer an outlandish forecast.

The Bank of England has so far been content to look through what it assumes will be a temporary overshoot of its inflation target. It judges the cost—in terms of lost economic outpoint, lost wages and lost jobs—of bringing inflation down to be too high. How long it will be prepared to tolerate above target inflation will depend on two crucial factors. The first is expectations of future inflation, the fear that if households, firms and the financial markets come to expect that inflation will usually be higher in the future (in the jargon, if expectations become “decoupled” from the Bank’s target) then those expectations could become self-fulfilling.

The second—as with so much else—is how the domestic economy performs. Last August the Bank cut interests rates and restarted its programme of quantitative easing (electronically creating money to buy bonds) in order to ward off a slowdown. That slowdown has been as pronounced as they feared. Whilst most of the rise in UK inflation over the past year can be blamed on international factors (like oil prices) or the pass through from a weaker currency, if evidence starts to mount of rising domestic price pressures then the Bank may feel more inclined to take action. That though, still feels someway off.

But whilst no policy change from the Bank appears imminent, households are already starting to feel the pinch. 2008 to 2015 saw a long squeeze in the level of real average weekly earnings (weekly pay minus inflation) as inflation was generally elevated and pay growth historically weak. The lower inflation of 2015 and 2016 coupled with a small uptick in cash pay levels drove real wage growth higher. But that now looks to be coming to an end.

Real average regular weekly pay growth in the year to February (the latest data we have) was just +0.1 per cent. That’s down from 2 per cent plus in late 2015 and early 2016 and from over 1 per cent as recently as last summer.

The level of unemployment remains low and, by many traditional measures, the labour market appears to be relatively “tight” but that is failing—as many models would suggest—to drive wage growth higher.

It may be that the weakness in productivity growth means that firms don’t feel they can expand wage bills without a profit squeeze or perhaps that Brexit-related uncertainty is making firms unwilling to make generous pay settlements.

Whatever the driver though, soggy wage growth coupled with higher inflation is a recipe for a squeeze in real incomes. That squeeze, hopefully, won’t be as long or deep as the 2008-2015 one was but that won’t be much consolation for households facing their second period of falling real incomes in a decade.

The crucial question facing the UK economy—and the Bank of England—now is how consumers will react to a fall in real wages. Will they trim back their spending in response or will they draw down savings and increase borrowings to maintain it?

In the second half of 2016, households chose keep on spending even as real income growth slowed, pushing the ratio of household saving to income to a new low. If that trend continues then the UK demand growth will remain relatively strong in 2017, growth won’t falter too much and the Bank may be looking to raise rates at an earlier stage than originally planned. But if households take fright at falling real incomes and trim their spending back then economic growth will slip and a rise in interest rates—despite higher inflation—will feel a very long way away.