The Bank of England’s new chief economist, Huw Pill, states that high levels of UK inflation may persist for longer than expected. But why are prolonged high levels of inflation significant to the economy, and what can we do to reduce it?
Why is inflation rising?
The more recent rise in UK inflation has been rooted in the increasing costs of imported goods, as well as international commodity prices. This is known as cost-push inflation, where overall prices increase due to an increase in wages and raw materials (in this case, specifically raw materials). Cost-push inflation can occur when higher costs of production decrease the aggregate supply (the amount of total production) in the economy.
Why are the high levels a concern?
“In my view, that balance of risks is currently shifting towards great concern about the inflation outlook, as the current strength of inflation looks set to prove more long-lasting than originally anticipated,” said Huw Pill, in his first public remarks since taking office last month. Markets are currently expecting a 15 basis point rate rise by February, with an increased likelihood of the first increase at the December meeting.
In the BoE’s policy statement in September, they said they’d expect the consumer price inflation to reach approximately 4% later in the year, well above the 2% bank target, and to remain high for some time. “Over recent months, inflation has surprised to the upside,” noted Pill. “The risks to the economic and inflation outlook are again clearly becoming two-sided,” he argued, adding this contrasted with previous periods when weakness in the economy “skewed risks to activity, employment and inflation to the downside.”
High inflation has a regressive effect on lower-income families and older citizens who might be living on a fixed income. If prices are rising faster than wages, then there will be a decline in real incomes. High inflation can lead to an increase in pay claims as people look to protect their real incomes. This can lead to a rise in unit labour costs and lower profits for businesses. However not all workers belong to strong trade unions that can use collective bargaining power to bid for higher pay. Inflation tends to redistribute income and wealth towards those who are more able to protect themselves against inflation due to owning assets that earn consistent returns.
If interest rates on savings accounts in banks are lower than the rate of inflation, then people who rely on interest from their savings will be poorer. Real interest rates for millions of savers in the UK and many other countries have been negative for at least four years. High inflation may also lead to higher borrowing costs for businesses and people needing loans and mortgages as banks try to protect themselves against rising prices. High inflation puts pressure on a government to increase the value of the state pension and unemployment benefits and other welfare payments as the cost of living climbs higher. A rise in actual inflation can lead to an upward shift in inflation expectations (which can be modelled using the Phillips Curve).
What can be done to reduce the impact?
Increasing the base interest rate raises the cost of borrowing for commercial banks. With more cash held in bank accounts and less being spent, money supply tightens and demand for goods lowers, making them cheaper, lowering inflation.
Traders are currently betting on interest rates rising from 0.1% to 0.75% by the end of 2022. Pill believes he could vote in favour of an early rise in interest rates. “He has placed himself on the hawkish side of the MPC and, if we’re looking at people who might switch camps to vote for tighter policy, Pill is probably now the one to watch most closely,” said Andrew Goodwin, an economist at consultancy Oxford Economics.
Written by Sanjana lyer
Research compiled by Hugo Denage