Opinion editorial by Stuart Cole, Head Macro Economist at Equiti Capital

• UK policymakers continue to insist inflationary pressures remain transitory
• But as CPI prints higher, is an element of sustainability now appearing?
• And does this leave the BoE in danger of reacting ex-post rather than ex-ante?

26 July 2021

The message from the Bank of England (BoE) remains that inflation is transitory, that supply chain disruptions caused by Covid-19 and Brexit are creating temporary price pressures that will dissipate over the course of next year.  It forecasts CPI to reach 3% this year before returning to target in 2022.  However, the departing Chief Economist has suggested this figure could be closer to 4%, with no guarantee of any subsequent easing, while 10-yr Gilt yields remain around 50bps higher than end-2020.  Clearly the BoE’s view is not universal.

But despite these inflation concerns and only an expectation from the BoE that prices will subside again (it says they “should” subside, not they “will”), it continues to pump £3.4bn of additional stimulus into the economy each week.  Accordingly, is it taking a gamble with inflation and, by implication, UK living standards?

Inflation remains on the rise

The most recent figures showed annual headline CPI rising to 2.5% in June, driven primarily by increases in clothing, catering services, second-hand car prices and fuel.  With consumer demand bouncing back strongly following the lifting of Covid restrictions, businesses appear to be taking advantage of this recovery and raising prices where they can.  The key question is whether these increases will remain permanent or not.  Evidence so far suggests they could be.

Retail sales data showed that over April and May, when lockdown restrictions started to be eased, sales volumes were 7.7% higher than in March, and 9.1% higher than in February 2020 before the pandemic hit, i.e., consumption is growing and stronger now than it was pre-pandemic.  Despite the higher prices being faced, consumers appearing willing to pay them.  The sustainability of this consumption – and by implication the price increases too – will become clearer as more data is released over the course of the next few months.  But so far, the evidence suggests the BoE’s transitory argument may be flawed.

Sentiment surveys suggest rising prices are becoming embedded

Further undermining the ‘transitory argument’ are the recent Markit/CIPS surveys, which showed prices rising strongly across all three sectors covered, a mixture of stock shortages, higher sub-contractor/staff costs, rising input prices and demand/supply imbalances all contributing to prices rising at their fastest levels for 25 years.  Certainly some of these rises will be transitory, e.g., price increases caused by supply/demand imbalances should ease as output catches up with demand.   But some of them are already looking permanent, such as increased wages bills and the additional post-Brexit costs of trading with the EU.

However, perhaps most importantly is that the surveys showed respondents themselves starting to view some price rises as embedded.  For example, the services sector reported rising demand alongside rising prices, while in the construction sector new orders were reported as growing at their fastest pace since 2007 despite prices increasing, end-consumers appearing prepared to absorb higher costs.  Crucially, a trend can be seen growing to classify price rises as either transitory or sustainable: the BoE’s view of predominantly transitory inflation does not appear to be fully aligned with business thinking.

Is Government policy contributing to higher prices?

A key pillar of the Government’s economic support during the pandemic has been the jobs furlough scheme.  Widely credited with having prevented unemployment from rising sharply, as the economy now emerges from the pandemic there are suggestions the scheme is causing problems itself via its prohibition on furloughed workers seeking alternative employment.  While a significant proportion of furloughed jobs are expected to disappear when the scheme finishes end-Q3, until then this pool of labour remains unavailable to fill vacancies and is being partly blamed as one reason for the labour shortages being seen in sectors such as hospitality, where wages are rising in consequence.  With rising wages one of the key mechanisms via which price rises can become permanent, the BoE may be gambling on rising unemployment from Q4 onwards bearing down on these strengthening labour costs.

Will savings allow households to give themselves a pay rise?

Lastly, the large savings stock built up over the pandemic represents a potential source of income households could use to fuel consumption.  Low interest rates coupled with rising CPI boosts the chances that consumers will decide to ‘give’ themselves a ‘pay rise’ funded from these savings, allowing price rises to be absorbed and consequentially become embedded.   Further, an extended period of above target inflation also risks reappraised inflation expectations feeding into wages claims, and whether financed by employers or savings, makes rising prices that much harder to eradicate.

Ex-ante versus ex-post

The above arguments clearly are not the central view of the BoE and there is no suggestion it is going to move away from its transitory inflation view any time soon.  But even if not the central view, they represent risks that are growing, with a failure to adjust policy in a timely manner potentially seeing interest rates tightened faster and higher than might have been needed, leaving businesses and households facing higher borrowing and living costs and governments higher debt-servicing costs.  When it comes to controlling inflation, it is always better to act ex-ante rather than ex-post.

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