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Unless we see a major escalation of events in Ukraine, the impact of rising food and energy prices on inflation is likely to recede in the second half of 2022. The recent fall of many commodity prices also supports this. However, there will be some economic costs associated with the ongoing transition to a green economy (partly encouraged by the move away from dependence on Russian hydrocarbons). These may be manifested in higher and more volatile inflation. For example, if a greater proportion of our energy is reliant on the weather, this will result in more volatile energy prices.
Rising prices for all type of goods was a main inflation driver during the pandemic but this has lessened recently. We would expect goods inflation to decline dramatically this year. Bank of England research shows that goods inflation is over twice as volatile, but less than half as persistent, as services inflation.
Given the tightness of labour markets, wage growth poses a bigger inflation risk than it has done over the past two decades. We need to consider the impact on inflation, and the likelihood of it persisting. Our own research has found that the low inflation of the past two decades can be attributed to a weakened relationship between wages and prices. Rising inflation 40 years ago was in part due to a wage-price spiral – rising costs led to rising wages that then created and encouraged further rising costs. Though onshoring of manufacturing and rising geopolitical tension may see the relationship between wages and prices strengthen, we do not expect a return to those previous wage-price spirals.
We would expect the demand for labour to ease gradually over the next year. This will be driven by a modest rise in labour force participation, slowing economic growth and the potential for lower labour intensity, as businesses adjust to the post-Covid normal. Importantly, membership of labour unions has fallen significantly in both the UK and the US, reducing the bargaining power of workers, and the capacity for wage-price spirals.
Energy and food price inflation is having a direct impact on the spending of consumers, thereby limiting their ability to help sustain economic growth. This makes it difficult for governments and central banks to address the problem – it’s a fine line between taming inflation and choking off growth.
Central banks can try to address rising inflation by making financial conditions tighter (for example by raising interest rates). This causes demand for goods and services to slow and inflation to ease as a result. However, it’s more difficult for central banks to bring inflation down when it’s the result of supply shortages, as we’re seeing currently.
High inflation can be a risk for an economy. It contributes to a fall in real incomes (income adjusted for inflation) meaning people are less likely to spend. A second risk lies in the response inflation can warrant from central banks. Central banks risk slowing economic growth too much and tipping the economy into recession.
In the UK, as a result of the current bout of inflation, we expect to see the largest fall in real incomes in over 30 years. Given private consumption in the UK accounts for over 60 per cent of GDP, this is challenging for economic growth.
In addition to the current drop in real-income illustrated above, we’re also seeing evidence of this economic challenge in consumer confidence surveys, which have been deteriorating in the UK since last summer.
Another risk of higher prices is that inflation expectations become unanchored, as we saw in the 1970s and 1980s. This is challenging for central banks as it can cause high inflation to become self-fulfilling – if workers expect inflation to be high, they’ll demand higher wage to maintain their purchasing power. Businesses then try to pass this increased cost onto consumers, leading to a wage-price spiral.
The current environment is also challenging because of the delay between raising interest rates and the impact it has on inflation – which could be as much as 18 months. This lag means central banks are reluctant to raise interest rates to correct demand-driven inflation, as they would expect the economy to respond by increasing supply.