Why inflation is worse than anyone expected – and what comes next
Tim Wallace
5 min read
andrew bailey bank of england
Three shocks have stalked the British economy and sent inflation through the roof, in Andrew Bailey’s reading of the crisis.
The first was the Covid pandemic, which shattered supply chains, disrupted trade and sent more money chasing fewer products. Prices jumped.
The second was the war in Ukraine. Vladimir Putin’s invasion forced the price of crucial commodities, including energy, food and metals, through the roof.
The third would normally look like a blessing: Britain’s very low unemployment rate. But the extremely tight jobs market means companies are struggling to find the workers they need, strangling their growth and forcing them to offer bigger pay packets to get the staff, which in turn feeds more inflation.
This is the big threat now. Higher pay helps embed inflation into the economy, making price rises more persistent and spreading it into industries which might have dodged the worst of the initial surge in global food and energy prices.
The Bank of England’s Governor has warned about this. But his words, and even his interest rate rises, have been too little to stop price rises taking hold.
The result is that inflation is falling only slowly. Prices in May were up 8.7pc on the year, according to the Office for National Statistics, the same rate as recorded in April. This surprised economists who expected a drop to 8.4pc.
Big changes include airfares - up by almost one-third, though this can be affected by the timing of the Easter holidays - live events, which may have been affected by shows by big stars including Beyonce, and second hand cars, which are less exciting than pop sensations but typically more important as a major household expense.
More ominously for the economy as a whole, core inflation, which strips out factors including energy and food, in a bid to remove some major imported items and so focus on the domestic economy, is accelerating. Core inflation hit 7.1pc in May, a 31-year high.
Not only are domestically generated prices accelerating, but this step upwards comes after something of a plateau in the rate.
From April 2022 to March of this year, core inflation hovered at around the 6pc mark. This was still an uncomfortably high level, but raised the possibility that at least the rate of inflation was not getting any worse, and so perhaps the Bank’s rate rises since December 2021 had reined in pressure in the domestic economy.
That tantalising hope has now slipped away, with core inflation rising to 6.8pc in April and 7.1pc in May.
The problem is not only that inflation has gone from an imported problem to a local one.
It is also that the type of costs facing consumers has also changed.
In terms of inflation, the big crises of the pandemic and the war revolved around goods.
Lockdowns across the globe disrupted factories churning out goods, and then cargo ships’ ability to transport them to customers.
The most intense phase of these crises is over. Goods price inflation has at last dropped back below 10pc in the UK.
Instead, pressure is mounting in the services side of the economy.
These tend to be produced locally - cleaners, dentists, train drivers, chefs and many more all need to be there in person. Live events were a particularly big driver of higher inflation in May. Eating out is getting more expensive.
Prices for services have been rising less rapidly than for goods in recent years, but still persistently.
Now services inflation is accelerating even as goods inflation slows. Services prices are up 7.4pc on the year, which is faster than the 6.9pc rise recorded in April.
James Smith, economist at ING, says this shows higher costs are seeping into more of the economy.
“The Bank of England is most focused on services inflation because it tends to exhibit more persistent and less volatile trends,” he says.
“And here we saw a further increase in the annual rate of inflation, and that means the contribution from services to overall headline CPI is about 0.3 percentage points higher than the BoE had previously been forecasting. Crucially, this upside surprise doesn’t appear to be concentrated in any single category.”
A key cost here is labour, and wages are surging.
Pay jumped at a record pace in the latest numbers. Regular earnings in the three months to April were up 7.2pc on the year, the sharpest rise on record, excluding the pandemic when furlough distorted the figures.
This suggests inflation is well and truly becoming embedded in the economy.
The Bank of England warned about this – Bailey came under fire last year for urging pay restraint.
There are few signs of this going away. There are still more than 1m job vacancies available in the economy. Companies still need workers and are struggling to find them.
To further cause concern, those services also in turn feed into goods.
The food sector shows this painfully. Even though prices on world markets have fallen, this is yet to be felt on supermarket shelves.
Karen Betts, chief executive of the Food and Drink Federation, says this is because everything else involved in getting food to families has become more expensive too.
“The fact remains that the cost of ingredients, energy, labour, packaging, logistics and other inputs remain stubbornly high, and still some way above pre-pandemic levels,” she says.
Inflation feeds inflation. That is a painful feedback loop, and the Bank of England has failed to break it so far.
