Putting The Brakes On Inflation

Inflation is a sustained rise in an economy’s general price level, measuring the increase in the cost of living.

There are multiple reasons why it may occur within an economy, all of which could be summarised under the umbrellas of either an increase in the cost of production (cost-push inflation) or an increase in demand which is not adequately mirrored by a change in supply (demand-pull inflation). In both cases, the result is the same: prices in the economy increase and are often unlikely to decrease by themselves.

In practice, inflation is often less terrifying than it sounds: as long as it is moderate and stable, its presence encourages consumption and hence the growth of the economy, and it can be met by increases in households’ incomes that minimise the impact felt as a result of the higher shelf prices. In the UK, the Bank of England (BoE) has a target of 2% (with a margin of ± 1%) using the monthly-calculated Consumer Price Index (CPI), which has been considered as optimal in this regard.

But here is the problem: recently, the rate of inflation has risen the fastest in 10 years. In the 12 months leading up to October 2021, the CPI increased by 4.2%, more than doubling the BoE’s target and exceeding the 3.9% CPI figure expected by economists polled by Reuters. It is a case of a 28.1% increase in gas bills during the year, but also of grocery price inflation reaching 2.1% in the four weeks leading up to the 31st of October.

The situation becomes even bleaker in light of the recent statement made by Andrew Bailey, the governor of the BoE, warning that inflation could climb “as high as 5% before falling back again.”

What has gone so horribly wrong since July this year when the CPI was at the ideal, coveted 2%?

How did we come to experience such a sudden, worrying increase in the cost of living, and is it going to persist?

When considering the past four months, a lot of possible causes become clear. From the increase in the demand for oil and gas has pushed up energy prices worldwide for both households and firms, to shortages of goods such as computer chips, to the UK-specific shortage of lorry drivers and hospitality staff, it is not difficult to pinpoint the amalgamation of contributors to the current state of inflation.

The BBC especially focuses on the recent increase in fuel and energy prices, which doesn’t only affect consumers directly (automotive services company RAC has said that it is £15 more expensive to fill up an average family car than it was in 2020) but also indirectly, as firms’ higher energy costs are passed on partially to their customers. In October, energy regulator Ofgem has lifted the price cap it had imposed on domestic gas and electricity prices, removing the protection this offered households against any increase in their energy bills. This was done in response to 12 energy suppliers that have gone bust, unable to absorb the higher costs of the astronomical 250% rise in natural gas prices.

Hopefully, the removal of the cap will allow firms to stay afloat by increasing prices, but in protecting their interests the flood gates to inflation have been opened. Whether prices will stabilise shortly or not is a complex question; generally, it is expected that by the second quarter of 2022 prices could normalise as the end of winter in Europe and Asia eases seasonal pressures. This said research agency Cornwall Insight predicted an eye-watering 30% rise in energy bills next year and the persistence of volatility.

The picture is not a pretty one, and there are certainly no rose-tinted glasses to be worn. Even if the issue of natural gas prices was to be magically willed out of existence, we would still be facing the labour shortages in key industries, which according to the OECD has partly occurred due to the pandemic but has also been compounded by Brexit and the enormous barrier to the movement of labour that it poses.

If inflation is to persist at the same rate as the one experienced this year, the effect may be beyond just sizeable. Despite nominal increases in wages, many workers may likely have lower incomes in real terms, and people on fixed incomes such as pensioners will be progressively worse off, which means that the welfare of many is under threat.

As a result, inflation must be urgently tackled, and, indeed, in the “coming months,” the BoE claims it might have to use contractionary monetary policy, increasing the Official Base Rate of interest (the OBR) which has stood at 0.1% since March 2020. In theory, this should be an efficient way of reducing inflationary pressure by decreasing the aggregate demand of the economy, and, likely, this will indeed be the outcome.

However, it is important to note that this method is not tackling the cost-push inflation seen from the labour shortages which led to higher wages or the rise in the price of natural gas.

Instead, this will dampen consumption financed from borrowing as well as, possibly, investment. Higher interest rates are likely to widen the gap between the richest and the poorest since high earners have a higher marginal propensity to save, and the return on those savings is increased. Separating the effect of an increased OBR to the cause for it happening, the creation of a less equitable distribution of income whilst the pandemic is still negatively affecting many households seems to be a less than the optimum decision.

Evaluating the urgency and severity with which inflation must be tackled is difficult. If it is left alone, prices could continue increasing at unprecedented levels and hurt consumers. Likewise, if tackled by the BoE harshly, the disparity between low-income earners and high-income earners could grow. The current situation is one that warrants careful analysis, especially as there are no comparable precedents to the harmful concoction of the pandemic and Brexit’s effects on the economy. One clear thing is that the BoE must (and is planning to) put the brakes on inflation, but we can only hope that there are also airbags in place to shield those hardest hit.


Written by Nicola Craciun

Research compiled by Billy Ryan

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