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The UK is currently grappling with an inflation rate that stubbornly refuses to decline as quickly as anticipated by forecasts. This stickiness can be attributed to two main factors: a wage-price spiral and sticky import price penetration. The Bank of England's forecasting failures may also have inadvertently contributed to de-anchoring expectations away from the target, potentially fuelling runaway inflation.
A wage-price spiral refers to the situation whereby workers demand higher wages to retain purchasing power vis-à-vis the rising costs of living, and employers pass these costs onto consumers in the form of higher prices, leading to further wage demands and a vicious cycle of inflation. This phenomenon is currently being observed in the UK, where labour costs have been identified as a significant driver of core inflation. The pandemic and the state of the NHS have contributed to labour market inactivity through long-term sickness, which has additionally detrimentally impacted labour costs. Notably, pay increases for many workers are still not keeping up with rising prices.
Sticky import price penetration is another factor contributing to the UK's high inflation. The UK, being a net energy importer, was hit harder by the surge in energy prices following Russia's invasion of Ukraine. The post-Brexit border paperwork has resulted in longer supply chains, meaning that supply shocks, such as those caused by weather, hit UK shelves harder. The rise in import costs has depressed the purchasing power of the country as a whole.
The Bank of England's forecasting failures may have also played a role in the current inflation crisis. The UK reported a consumer price inflation of 8.7% for April, significantly above the Bank of England's forecast of 8.4%. The Bank's governor, Andrew Bailey, admitted that the central bank’s economic model had not been accurate and there were “very big lessons to learn” on the management of high price rises. This failure in forecasting could potentially de-anchor inflation expectations away from the target, leading to a self-fulfilling prophecy of higher inflation.
In spite of the acknowledgement of weakness, Bailey has defended the Bank's actions, arguing that the Bank could not have pre-empted the current wave of punishing inflation without hiking interest rates “well into double-digits” in the middle of the Covid-19 pandemic. He also pointed out that critics ignored the fact that Russia’s invasion of Ukraine played an especially large role in price rises.
Looking forward, the Bank of England seems set to raise interest rates closer to 5% to rein in price pressures. However, the hike of the bank rate will not manage the underlying mechanisms of the high core inflation rate in the UK, mostly attributed to labour costs. Rather, it may be implied that tackling inflation may require addressing the wage-price spiral and import price penetration. The Bank's ability to accurately forecast inflation will also be crucial in managing inflation expectations and preventing runaway inflation.
The stickiness of UK inflation can be attributed to a wage-price spiral and sticky import price penetration, with the Bank of England's forecasting failures potentially contributing to the problem. Addressing these issues will be crucial in bringing inflation back to target levels.