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Heat or Eat: An enquiry into the causes and effects of the current inflationary pressures


Prior to the COVID-19 pandemic, the UK economy saw a period of stable unemployment rates accompanied by low and stable inflation. (Ferreira, 2019) (Moya, 2019a) This was beneficial for the UK economy as it allowed for economic agents, such as businesses, to plan their investments ahead, increasing aggregate demand and reducing slack as output rose. (Clark, 2018) Yet, the recent COVID-19 pandemic has completely changed this trend as OECD nations have seen high inflation rates, with inflation forecasts reaching up to 7%. (Nachiappan, 2022) The UK economy, in particular, has seen high rates of inflation, 5.4% (Moya, 2019b) CPI being the most recent figure, placing the UK inflation rate above the UK government 2.0% CPI target, as shown below.

As such, because the CPI inflation rate is above target, the government is likely monitoring inflation. This is because high and unstable inflation has different economic effects on different economic agents - in other words - to understand whether inflation matters, different sectors of society must be explored. One of these groups are consumers, particularly those on fixed incomes, who see high inflation rates as a cost as price levels rising at a faster rate erodes purchasing power. For example, those on state pensions or JSA, who are already vulnerable, are unable to increase their incomes compared to their employed counterparts who have seen wage growth. (Trading Economics, 2019a)

Consequently, this reduction in purchasing power gives these consumers three options; take on debt to retain living standards, switch from normal goods to inferior goods, or, cut back on certain goods altogether. Unfortunately, it seems that in the UK at least, the most vulnerable consumers have had to resort to the last option as the Trussell Trust released a record amount of emergency food parcels in 2020. (Trussell Trust, 2021) This creates a problem for these individuals; a state pensioner having to choose between food or heating, who is already exposed to illness due to their age, is more likely to develop health problems as they are forced to ration necessities, which, can cause a horrible opportunity cost, considering the recent rise in gas prices as fuel poverty can occur. (Ambrose, 2022) Similarly, a family on JSA will have more trouble rationing its increasingly scarce income between their children during times of rising inflation rates, and, whilst this may result in children not being properly fed - especially in holiday periods or in lockdowns where they do not have access to free school meals (Social Market Foundation, 2020) - the more common cases are scenarios where a vulnerable family cannot allocate as many resources due to higher inflation rates towards technologies such as mobile phones, which, have become essential for learning during the pandemic. (Vibert, 2020) Additionally, a scarcer budget makes it more likely for a family to have problems with money, one of the biggest reasons why families break apart. (Vulliamy, 2016) The fallout of this can further hurt children, as well as their parents' development by causing mental health problems. (Department for Work and Pensions, 2021) All of these examples show how high rates of inflation can further reduce the living standards of individuals both in the short-term, through cutting back on goods, and, in the long-term, through potential health and development problems on those most vulnerable in society. As it stands, being forced to ration certain goods due to reduced purchasing power not only reduces the living standards of the adult consumer but can also begin to erode the opportunities children have of escaping their caregiver's income bracket at early ages making inflation matter.


These negative effects for the consumer of high rates of inflation also matter for the government as these can widen inequality in the long-term, the opposite of the government's objective. (GOV.UK, 2018) The COVID-19 pandemic has already yielded a rise in inequality,(Social Mobility Commission, 2021a) and, this is likely to persist in the long term as the aforementioned costs of inflation decrease opportunities for the development of ones child if they are unlucky to be of lower socioeconomic status, meaning that children of parents within higher-income brackets, who have more security, will have better opportunities for success after the pandemic. (Montacute, 2020) As such, high rates of inflation will make it harder for children to develop in a way so that they can escape relative poverty once they are adults. (Social Mobility Commission, 2021b) Consequently, as more individuals find themselves stuck in low-income brackets, or, with no job as they did not have the opportunity to develop key skills, they are more likely to rely on government welfare such as JSA. This means the government will be pressured to allocate more funding to these areas as claimant count figures are higher (Powell, Francis-Devine and Foley, 2021) to ensure that those on fixed incomes can retain their living standards during periods of high inflation. As such, because the UK government has an already scarce operating budget, and, with national debt being at record levels, (Office for National Statistics, 2021a) the opportunity cost of having to choose between focusing on debt repayments, which will become more expensive if interest rates continue to rise due to the MPC of the Bank of England implementing further contractionary monetary policy to bring inflation down, (Giles, 2021) and welfare is unfavourable. Furthermore, the previously mentioned mental and physical health issues attributed to an increasingly scarce income will also place extra strain on the NHS, a service that is already over-encumbered with 6 million waiting for treatment (Campbell and Duncan, 2021) considering that there are 90,000 vacancies. (Campbell, 2021) Once more, this creates another opportunity cost for the government as spending more on the NHS to retain the living standards of those affected by high rates of inflation becomes regrettable. Hence, the costs of inflation to the consumer, especially those in lower socioeconomic status, transition to even heavier costs borne upon by the government, and, this shows that the effects of inflation - or inflation itself - matters greatly to economic agents, especially government, who, recognise these costs and will likely want to work towards rectifying these by bringing inflation back to the 2.0% CPI target.


To do this, the government has two tools at its disposal, monetary and fiscal policy. Yet, these are demand-side policies, as such, for these to work, the recent rise in the inflation rate must be attributed to an increase in aggregate demand. And, this is partly the case as, during the COVID-19 pandemic, the UK government implemented the Furlough Scheme, this combined with existing automatic stabilisers such as JSA, meant that unemployment levels during the pandemic did not see massive fluctuations, preventing a negative multiplier effect. (Plummer and Palumbo, 2020) This meant that liquidity within the economy was retained as consumers, who were already unlikely to spend due to low confidence, saved record highs. (Partington, 2021) Therefore, once confidence was restored in the UK economy, particularly due to a successful vaccine rollout, (Romei, 2021) consumer spending, which accounts for approximately 66% of aggregate demand, (CIA World Factbook, 2022) rose, increasing aggregate demand and yielding demand-pull inflation. This also drove further economic activity as business investment grew at a record rate due to increased consumer spending, (Office for National Statistics, 2021b) causing a multiplier effect in the UK economy. As such, output rose, yet, although GDP levels are at their pre-COVID peaks, (Wearden and Inman, 2022) inflation rates are still much higher. (Moya, 2019c) This means that it is not just an increase in aggregate demand that has caused a drastic rise in the rates of inflation, because of this, it is important to analyse whether cost-push inflation has occurred to conclude whether the government can actually do anything to rectify this.


The pandemic yielded a halt in global output (World Bank, 2020a) as the reduction in aggregate demand meant that firms had a decreased incentive to produce goods and services as profit levels were lower. This meant that at the start of the pandemic the UK saw high redundancies (Statista, 2022) as firms had to cut back on factor inputs. These low-profit levels also made it harder for firms to replace depreciated capital. (D’Acunto and Weber, 2022a) As such, the capacity that firms had to produce goods and services decreased during the first lockdown period, (Partington, 2020) for example, many shipping firms scrapped their fleets of cargo ships to retain liquidity. (Paris, 2020) Consequently, this meant decreased capacity, leading to reductions in aggregate supply, yielding cost-push inflation. In fact, this pattern is still occurring as nations such as China are still experiencing frequent lockdowns that are reducing the capacity of their ports. (Swanson and Bradsher, 2022) (Hille et al., 2022) This combined with rising container costs (Jones, 2021) makes cost-push inflation a problem for the UK economy as 27% of the UK’s GDP is allocated to imports. (World Bank, 2020b) As such, because imports make a significant portion of UK GDP, it is logical to assume that any fluctuations in international trade costs will be passed onto the consumer. This is especially the case with goods such as oil, which, due to the Marshall-Lerner Condition, will still be imported by the UK, even at a higher price, as the commodity is used for petrol, a good that is vital for the logistics of the UK’s economy. Consequently, although international reductions in capacity are leading to cost-push inflation, it is also important to look at more domestic reasons as these can be focused upon by the UK government.


It has been established that due to COVID-19, firms have struggled to increase their capacity back to pre-COVID levels, this means that when aggregate demand levels surged in the UK, firms were unable to instantly accommodate, yielding an increase in price levels as products effectively became more scarce due to a sluggish recovery. (Romei and Strauss, 2022) Yet, GDP in the UK economy is rising, (Ferreira, 2021) meaning that the increasing economic activity is incentivising firms to increase their production levels to make higher profits, as such, businesses are trying to recoup their lost output. Yet, this is difficult to do as to avoid diminishing, or even negative marginal returns, firms must increase all factor inputs at the same rate - the problem is, labour is hard to come by. The UK has a record number of vacancies as firms attempt to scale output, (Office for National Statistics, 2022a) yet, although unemployment has fallen, inactivity is rising. (Office for National Statistics, 2022b) This phenomenon can be shown by the relationship between the UK's unemployment and inflation rate changing over time as shown below in the dataset.

This has seemingly has caused the Phillips Curve of the UK economy to become more inelastic. Meaning that levels of unemployment in the previous year yielded lower levels of inflation than this year. There are a few possible reasons for this, the first could be the effect of the Furlough scheme on attitudes to work in the UK as, after the conclusion of the scheme, sectors such as hospitality and tourism have not retained their workers (Race, 2021) as Furlough changed why people want to supply their labour in certain industries as people are now more likely to pursue what they find meaningful (Barnett, 2021) which is especially the case with young people as more have entered further education. (Office for National Statistics, 2021c) At the same time, COVID has restructured the economy, meaning that labour markets are adjusting as people are now more likely to look for jobs with better benefits such as working from home. (Dhingra and De Lyon, 2021) Furthermore, although wages have been rising, wage growth has lagged behind inflation, (Partington, 2022) as such, people recognise that they are seeing a pay cut, and are now less likely to work. All of these factors have created a scarcity of labour as individuals refuse to participate in the labour force yielding a reduction in labour force participation rates, (Trading Economics, 2021) leading to cost-push inflation as firms have had to increase wage rates to incentivise one to provide their labour. Yet, this could lead to a wage-price spiral as rising wages will lead to higher consumption, and higher inflation, (Mann, 2022a) which could make the Phillips Curve even more inelastic as workers' expectations about inflation adapt to the new environment, (The Investopedia Team, 2019a) meaning that the high inflation may not be transitory as a wage-price spiral continues to raise labour costs for firms with scarce operating budgets, yielding longer periods of cost-push inflation and exacerbating the negative effects of high inflation on economic agents.


As such, although the effects of inflation matter to the government, unfortunately, due to the high rates of inflation being attributed to cost-push factors, the government's use of fiscal and monetary policy cannot alleviate supply-side issues, making inflation meaningless in the sense that the government does not have a remedy to bring inflation back to target. Yet, this may not be a matter of concern as supply-side inflation is usually self-correcting by the free market. For example, rising container prices due to lower output mean that shipping firms have increased incentive to build more container ships, meaning in the long-run, capacity will return to pre-COVID levels. (Farrer, 2021) Further, the wage-price spiral scenario is unlikely to happen as the unemployed will eventually have to accept market wages even if they lag behind inflation as JSA payments will not suffice to provide one with an equitable standard of living. In the long run, the Phillips Curve relationship between unemployment and inflation also begins to break down, (The Investopedia Team, 2019b) meaning that, eventually, the shipping costs will be corrected by the free market, and the labour-market will adjust. (Mann, 2022b)This means inflation is likely to be transitory in the sense of time, but, the previously mentioned long-term costs of high rates of inflation towards economic agents such as consumers and government show how when using Jerome Powell’s recent definition of transitory inflation, where inflation results in permanent economic damage, (Leonhardt, 2021) then, in judgement, this current inflationary period can be seen as non-transitory as the costs of increased inequality, development, as well as government debt repayments are ones that will be borne by the British economy for a long time.

 

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