Inflation is back – and action to contain it is now needed

27 March 2017

By Andrew Sentance, Senior Economic Adviser, PwC

The rate of inflation jumped sharply last month and is now back above the Bank of England’s 2 percent target. We should not be surprised. Inflation is rising in major economies around the world.

Higher energy and food prices are part of the story. But even if they are excluded, the UK CPI inflation rate has picked up from 1.2 percent in February last year to 2 percent according to the latest figures. There is a more general rise in inflation taking place, which is being aggravated by the current weakness of the pound –pushing up the prices of a wide range of imported goods.

The pick-up in UK inflation from 0.3 percent to 2.3 percent over the course of the past year is the biggest increase in a 12-month period since 2010. Nor is this the end of the story. Further price rises are coming through the pipeline. Manufacturers are seeing an increase in the price of energy, commodities and components of around 20 percent on last year. The prices of goods leaving UK factories are 3.7 percent up on a year ago, the highest rate of increase since 2011.

Most economic forecasters expect inflation to rise to around 3 percent by the end of this year and to remain relatively high through next year. PwC’s latest forecast is for inflation to average 2.8 percent during 2018 – but inflation could easily be above 3 percent in some months later this year or next.

So we are facing a significant surge in inflation which could persist for a number of years. The last time we saw a big drop in the pound in the global financial crisis, it took several years to feed through into inflation. Inflation peaked at over 5 percent in the autumn of 2011 and then subsided over the course of the next few years.

The reaction of the Bank of England Monetary Policy Committee (MPC) at that time was to set aside concerns about the rise in inflation and to treat it as a temporary phenomenon.  But the situation now is very different.

First, the jobs market is now much stronger than it was in 2010/2011, when the unemployment rate was over 8 percent. Unemployment is now below 5 percent, the lowest level we have seen since the 1970s. We are close to full employment with nearly the highest level of job vacancies we have seen this century.

Second, the world economy now looks in much better health than it was in the early years of the economic recovery. This year, we are likely to see reasonably healthy growth in the three main regions of the global economy – Europe, North America and Asia.  The Eurozone economy in particular is now looking in much better shape now. As Europe is our largest export market, this is an important underpinning to UK economic growth.

Set against these positive factors, however, other influences are likely to dampen economic growth. Uncertainty about Brexit already appears to be affecting business investment, which fell by 1.5% last year, for the first time since the financial crisis. Consumers will also feel the squeeze from the rise in inflation – and that is already evident in the latest retail sales figures.

UK economic growth is therefore likely to slow somewhat over the next couple of years – but the latest PwC projections still suggest that GDP will rise at around 1.5% in 2017 and 2018. This will be disappointing relative to the period 2013-16 when the UK economy grew by around 2-3% a year but it is still quite respectable in the post-crisis “new normal”.

But this slowdown in economic growth should not deter the MPC from doing its job – which is to take policy actions to keep inflation in line with the 2 percent target. The Bank of England is now forecasting a prolonged period of above-target inflation over the next three years. A major contributory factor to higher inflation is a weak pound. And the weakness of sterling partly reflects the market expectation that the MPC will be reluctant to raise rates and follow the lead taken by the US Federal Reserve.

It is time for the MPC to change these expectations and show it is willing to act to counter inflation by gradually raising interest rates. If this is done slowly and carefully – as has been the case in the United States – it should not seriously dent economic growth. Instead, it might boost the credibility of the Bank of England and confidence in the UK economy, as well as taking some of the pressure off consumers by supporting the pound.

This is an edited version of an article which first appeared in the Daily Telegraph on 25 March 2017.

Andrew Sentance:
Read profile | Contact by email | Tel: 020 7213 2068

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