I have been
surprised by the extent and persistence of UK inflation over the last
few months, along with many others. So what did I get wrong?
Why is UK
inflation so persistent?
Let’s start by
looking for clues. The biggest is that inflation is proving more of a
problem in the UK than elsewhere. Here are a couple of charts from
Newsnight’s Ben Chu. The UK has the worst headline
inflation in the G7
and the worst core
inflation (excluding energy)
That Brexit would
make Inflation worse in the UK than other countries is not a
surprise. I talked
about this over a year ago, although back then US core
inflation was higher than in the UK. In that post I listed various
reasons why Brexit could raise UK inflation (see also here).
Could some of those also account for its persistence?
The one most
commonly cited is labour shortages brought about by ending free
movement. Here is the latest breakdown of earnings
inflation by broad industry category.
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Around the middle of
last year the labour scarcity story was clear in the data. One key
area where there was a chronic shortage of labour was in hotels and
restaurants, and wage growth in that sector was leading the way.
However if we look at the most recent data, that is no longer the
case, and it is finance and business services where earnings growth
is strongest. This dovetails with a fall in vacancies in the
wholesale,retail, hotels and restaurant sectors since the summer of
last year (although the level of vacancies remains above end-2019
levels). Has there been a recent increase in vacancies in finance and
business services? No, the explanation for high earnings growth in
that sector lies elsewhere.
Before coming to
that, it is worth noting that any earnings growth numbers above 3-4%
are inconsistent with the Bank’s inflation target, and the labour
market does remain tight, although not as tight as a year ago. One
partial explanation for UK inflation persistence is that it reflects
the consequences of persistently high (in excess of 3-4%) wage
inflation, which in turn reflects a tight labour market.
UK price inflation
is no longer just a consequence of high energy and food prices, as
this breakdown makes clear.
While energy and
food prices are still higher than average inflation, the most
worrying line from the Bank’s point of view is the green one for inflation in all services. It is
this category where inflation is (slowly) increasing, and the latest
rate of 7.4% is the main reason why UK inflation appears to be so
persistent. It is no longer the case that UK inflation is being
generated by external factors that cannot be influenced by the Bank
of England. That is also why it can be a bit misleading to talk about
inflation persistence or sticky inflation, because the prices that
are going up now are not the same as were going up just a year ago.
This high level of
services inflation could be a response to high nominal earnings
growth, with perhaps still some lagged effect from higher energy
costs [1], but recent data for profits suggests a third factor
involved. Here is the share of the operating surplus for corporations
(i.e. corporate profits) to GDP since 1997.
UK
Profit Share
Apart from a spike
in the first quarter of the pandemic, this measure of the profit
share has stayed below 24% since 2000, averaging about 22% between
2000 and 2022. However the end of 2022 saw this share rise to 22.5%,
and the first quarter of this year saw a massive increase to 24.7%.
We have to be careful here, as this sudden increase in the profit
share could be revised away as better data becomes available. But if
it is not, then it looks as if some of the recent persistence is
coming from firms increasing their profit margins.
Why might firms be
increasing their profit margins? This might not be unexpected during
a period where consumer demand was very buoyant, but with the cost of
living crisis that isn’t happening. It may be that firms have
decided that an inflationary environment gives them cover to raise
profit margins, something that seems to have happened in the US and EU. However another factor is Brexit once again. EU
firms now face higher costs in exporting to the UK, and this may
either lead them to withdraw from the UK market altogether, or to try
and recover these costs through higher prices. Either way that allows
UK firms competing with EU firms in the UK market to raise their
prices. If you look at what I wrote
a year ago, that effect is there too, but it was
impossible to know how large it would be.
What is to be
done?
The mainstream
consensus answer is to use interest rates to keep demand subdued to
ensure wage and domestically generated price inflation start coming
down. It doesn’t matter if the inflation is coming from earnings or
profits, because the cure is the same. Reducing the demand for labour
should discourage high nominal wage increases, and reducing the
demand for goods should discourage firms from raising profit margins.
In this context, the debate about whether workers or firms are
responsible for current inflation is beside the point.
That does not
necessarily imply the Monetary Policy Committee of the Bank was right
to raise interest rates to 5% last week. Indeed two academic
economists on the MPC (Swati Dhingra and Silvana Tenreyro) took a
minority view that rates should stay at 4.5%. I probably would have
taken that minority view myself if I had been on the committee. The
key issue is how much of the impact of previous increases has yet to
come through. As I note below, the current structure of mortgages is
one reason why that impact may take some time to completely emerge.
That demand has to
be reduced to bring inflation down is the consensus view, and it is
also in my opinion the correct view. There is always a question of
whether fiscal policy should be doing some of that work alongside
higher interest rates, but it already is, with taxes rising and
spending cuts planned for the future. Increasing taxes further on the
wealthy is a good idea, but it doesn’t help much with inflation,
because a large proportion of high incomes are saved. An argument I
don’t buy is that higher interest rates are ineffective at reducing
demand and therefore inflation. The evidence from the past clearly
shows it is effective.
For anyone who says
we should discount the evidence from the past on how higher interest
rates reduce demand because the world is different today, just think
about mortgages. Because of higher house prices, the income loss of a
1% rise in interest rates is greater now than it was in the 70s or
80s. Yet because many more people are on temporarily fixed rate
mortgages, the lag before that income effect is felt is much greater,
which is an important argument for waiting to see what the impact of
higher rates will be before raising them further (see above). There
is however one area where the government can intervene to improve the
speed at which higher interest rates reduce inflation, which I will
talk about below.
With the economy
still struggling to regain levels of GDP per capita seen before the
pandemic [2], it is quite natural to dislike the idea that policy
should be helping to reduce it further. This unfortunately leads to a
lot of wishful thinking, on both the left and the right. For some on
the left the answer is price controls. The major problem with price
controls is that they tackle the symptom rather than the cause, so as
soon as controls end you get the inflation that was being repressed.
In addition they interfere with relative price movements. They are
not a long term solution to inflation.
Sunak at the
beginning of the year made a deceitful and now foolish pledge to half
inflation. It was deceitful because it is the Bank’s job to control
inflation, not his, so he was trying to take the credit for someone
else’s actions. It has become foolish because there is a good
chance his pledge will not be met, and there is little he can do
about it. When challenged about making pledges about things that have
little to do with him he talks about public sector pay, but this has
nothing to do with current inflation (see postscript
to this)! As I noted
last week, the Johnsonian habit of lying or talking
nonsense in public lives on under Sunak.
The idea among
Conservative MPs that mortgage holders should somehow be compensated
by the government for the impact of higher interest rates is also
wishful thinking on their part, reflecting the prospect of these MPs
losing their seats. While there is every reason to ensure lenders do
everything they can for borrowers who get into serious difficulties,
to nullify the income effect of higher mortgage rates would be to
invite the Bank to raise rates still further. [3] Sunak cannot both
support the Bank in getting inflation down and at the same time try
and undo their means of doing so. In addition there are other groups
who are in more need of protection from the impact of inflation than
mortgage holders.
Another argument
against high interest rates is that inflation today reflects weak
supply rather than buoyant demand, so we
should try to strengthen supply rather than reduce
demand. Again this looks like wishful thinking. First, demand in the
labour market is quite strong, and there are no clear signs of above
normal excess capacity in the goods market. Second, the problems we
have with supply – principally Brexit – are not going to be fixed
quickly. To repeat, it is the domestically generated inflation rather
than the external price pressures on energy and food that represent the
current problem for inflation.
A similar argument
relates to real wages. People ask how can nominal wage increases be a
problem, when real wages are falling and are around
the same level as they were in 2008? Part of the
answer is that, as long as the prices of energy and food remain high,
real wages need to be lower. (The idea that profits alone should take
the hit from higher energy and food prices is ideological rather than
sound economics.) Because higher energy and food prices reduce rather
than increase the profits of most firms, they are bound to pass on
higher nominal wages as higher prices.
Yet there is one new policy measure that would help just a little with the fight against
inflation, and so help moderate how high interest rates need to go.
As I noted earlier, the sector leading wage increases at the moment
is finance and business services. In finance at least, some of this
will be profits led because of bonuses or implicit profit sharing.
Bank profits are rising for various reasons, one of which is that the
Bank of England is paying them more for the Bank Reserves they hold.
There is a sound
economic case for taxing these profits whatever is
happening to inflation, and the fact that higher taxes on banks could
help reduce inflationary pressure is a bonus right now.
What did I get
wrong? Just how bad the state of the UK economy has become.
While the Monetary
Policy Committee (MPC) of the Bank of England may have underestimated
the persistence of UK inflation, I have for some time been arguing
that the Bank has been too hawkish. On that, MPC members have been
proved right and I have been wrong, so it is important for me to work
out why.
A good part of that
has been to underestimate how resilient the UK economy has so far
been to the combination of higher interest rates and the cost of
living crisis. I thought there was a good chance the UK would be in
recession right now, and that as a result inflation would be falling
much more rapidly than it is. It seems that many of those who built
up savings during the pandemic have chosen (and been able) to cushion
the impact of lower incomes on their spending.
But flat lining GDP,
while better than a recession, is hardly anything to write home
about. As I noted above, UK GDP per capita has yet to regain levels
reached in 2018, let alone before the pandemic. If the UK economy
really is ‘running too hot’ despite this relatively weak recovery
from the pandemic, it would imply the relative performance of the UK
economy since Brexit in particular (but starting from the Global
Financial Crisis) was even worse than it appeared
just over a year ago. If I am being really honest, I
didn’t want to believe things had become that bad.
This links in with
analysis by John Springford that suggests the cost of Brexit so far
in terms of lost GDP may be a massive 5%, which is at
the higher end (if not above) what economists were
expecting at this stage. If in addition the UK economy is overheating
more than other countries (which is a reasonable interpretation of
the inflation numbers), this number is an underestimate! (UK GDP is
flattered because it is unsustainable given persistent inflation.)
Of course this 5% or
more number is really just our relative performance against selected
other countries since 2016, and so it may capture other factors
beside Brexit, such as bad policy during the pandemic, chronic
underfunding of health services and heightened
uncertainty due to political upheaval detering investment.
In thinking about
the relative positions of aggregate demand and supply, I did not want
to believe that UK supply had been hit so much and so quickly since
2016. [4] The evidence of persistent inflation suggests that belief
was wishful thinking. It seems the economic consequences of this period of
Conservative government for average living standards in the UK has
been extraordinarily bad.
[1] The UK was also
particularly badly
hit by high energy prices.
[2] In the first
quarter of this year GDP
per capita is not only below 2019 levels, it is also
below levels at the end of 2017!
[3] Higher interest
rates do not reduce demand solely by reducing some people’s
incomes. They also encourage firms and consumers to substitute future
consumption for current consumption by saving more and spending less.
However with nominal interest rates below inflation, real interest
rates so far have been encouraging the opposite.
[4] I probably
should have known better given what happened following 2010
austerity. While it is hard for politicians to significantly raise
the rate of growth of aggregate supply, some seem to find it much
easier to reduce it substantially.
