Inflation is back to stay

Inflation: friend or foe?

Inflation has been a big part of my life. When I was growing up, inflation was the economic enemy that had to be defeated at all costs. The oil price crisis in the 1970s and the battles between Government, employers and Trade Unions dominated the television news.   Then when I had the chance to work on the debt recovery programme in Argentina in 1989, I saw the impact of hyperinflation at first hand – the experience of the taxi fare home being double the fare out, just because the price index changed at midnight, sticks in my memory. However I also remember the upside: large nominal pay rises delivered twice a year to a low paid economist, even though I knew the amount was low in real terms.

My children have had a completely different experience. Living through the first decade of monetary policy independence they have heard little of inflation and have become used to seeing the prices of the things that matter to them, such as clothes and technology, consistently falling. But over the past few years we have seen the return of higher, and more volatile, inflation, albeit it nowhere near the levels of the 1970s and 80s. Even more striking to me, we now have an active policy debate on the potential benefits of higher inflation in helping reduce the debt burden in the developed economies. This would never have been possible when I was a lad. So what is happening to my old nemesis inflation?

Inflation is back

Inflation is back but not as I remember it. The increase in inflation rates has both external and domestic origins but it is not being created by the upward pressure on wages that we saw in the 1980s. Indeed the UK labour market has shown itself to be very flexible since the financial crisis with employment rising but average wage rises being very subdued. As a result, higher inflation has been damaging to the UK economy because of the way it has eaten into household spending power. The Ernst & Young ITEM Club estimates that had inflation averaged 2% over the past three years – rather than the 3½% it has been at– then the level of GDP would now be 2¾ppts or £10bn higher.

The return of inflation has been driven by higher commodity prices, in particular food, and rising prices of manufactured goods imported from emerging markets. In both cases the sharp depreciation of the pound in the aftermath of the financial crisis has compounded the impact on the UK. There has also been a marked step upwards in domestic inflationary pressures which has largely come from administered & regulated prices, such as domestic energy prices and university tuition fees. These categories account for just 10% of the inflation basket, but over the past six years they have contributed 0.9ppts to an average CPI inflation rate of 3.1%.

And there is no respite in sight. The Ernst & Young ITEM Club forecast suggests that CPI inflation is likely to go above 3% in the summer. Although inflation should cool in the Autumn, as domestic energy and food prices rise by less than they did last Autumn, EYITEM think it unlikely that inflation will dip below 2½%. This is partly because the trend of rising prices of imported goods from emerging markets is likely to continue, but also because administered & regulated prices are set to rise rapidly, particularly while the impact of higher university tuition fees continues to feed through. By the time that the tuition fees effect falls out of the calculation in late-2015, underlying inflationary pressures will be building again as a stronger economy improves workers’ wage bargaining powers and firms’ pricing power – then we might be back to inflation as I remember it.


Time to adjust

All sectors of the economy need to wake up to the likelihood of the new inflation reality:

  • Government and the Bank of England need to articulate a clear policy framework to allow consumers, investors and businesses to develop their thinking;
  • Consumers and households must reappraise their financial planning and management to take inflation into account: real and nominal prices are now diverging.

Inflation poses a real challenge for business and I have more to say on this in my next blog.


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