Hunt’s Lucky Day – are we finally done with inflation?

Intro

The same headlines that were touting the rapid climb of inflation in November 2022 are now celebrating inflation being controlled to a tame 4.6%. Has Sunak really achieved his top priority of ‘halving inflation’, or has he left behind a ticking time bomb for the victor of the 2024 general election?

In brief, inflation is rising prices, resulting in less purchasing power; the ‘value’ of each pound has reduced.
Inflation can be split into two main causes: demand pulled inflation or cost pushed inflation. In the case of demand pulled inflation, as aggregate demand rises, so does average price level.
Conversely, cost pushed inflation occurs after an increase in productions costs (such as higher wages needing to be paid to workers, or increased transport costs), so short-run aggregate supply reduces and price levels rise.

Towering prices – why has inflation risen?

Covid-19 resulted in significant disruption to the economy, including lockdowns preventing people from working, high street shops left empty, and factories stopped. With the opening of lockdowns globally, demand for consumer goods rose sharply. As people surged back into shops with very little stock to sell in the first place, the invisible hand drove up prices. A textbook example of demand-pull inflation, AD shifting out quickly meant that prices rose too.

Under pressure from excess demand and with an incentive to maximise profits, suppliers raced to increase their output. However, with the disruption to the supply chain after circuit breaker restrictions, many industries found themselves with higher costs than expected. Especially with supply-inelastic industries such as those dealing in raw materials or industrial products companies (according to EY), higher costs of production shifted supply inwards, increasing prices while limiting output. Labour-intensive industries, such as agriculture and food processing, have suffered considerably, with lockdowns preventing workers from going in and pushing up food prices. In March 2023, an all-time high of 19.2% food inflation was reported.

The impact of Covid’s supply-side shocks was compounded by other, unrelated events. The Russian invasion of Ukraine caused increases in energy prices across Europe and a scramble to review energy policies – sanctions imposed on Russian imported oil and gas have raised production costs and the burden of these has been shouldered by the consumer. Brexit’s lasting effects are still being felt – the lorry driver shortage has resulted in fuel prices spiking in 2021, while petrol prices broke 150p per litre in August 2023, after oil producers scaled back production.

The aftermath of Covid was already a ticking time bomb for inflation. Coupled with global shocks and greedflation, inflation spiralled through 2021 to 2023. Reaching an all-time high of 11.1% in October 2022 since 1981, inflation has caused the cost-of-living crisis to deteriorate. During a study conducted between February and May 2023, one in twenty adults reported that they ran out of food in the past two weeks, while 35% reported that it was very difficult to pay their rent or mortgage. To consumers whose wages are unable to increase in line with inflation, rising prices equal a decline in the standard of living.

Without countering inflation, lives were at stake.

A light at the end of the tunnel?

Following the rapid growth of inflation, the Bank of England responded by raising interest rates. The Bank continued to progressively increase its Bank Rate (from which commercial banks base their own interest rates), from 0.1% to 5.25% in the space of two years. Notably, during the height of the cost-of-living crisis in late 2022, the BoE suddenly increased rates by 0.75 percentage points, to try to alleviate inflation.

By increasing rates, households are encouraged to save more as their returns on savings increase. Since savings rise, disposable income for consumption reduces and AD should shift inwards; in the case of the current inflation crisis, AD’s rightward shift is slowed.

So far, it seems as though the high interest rates have succeeded. Inflation has been curbed to 4.6%, according to the latest reports in November 2023. The outlook is largely positive – this is the ‘lowest inflation has been since 2021’. Forecasts predict that inflation will arrive at the 2% target by the end of 2025.

A reduction in energy price, partly due to the governmental Energy Price Guarantee and price cap, and partly due to global energy markets ‘stabilising’, has contributed to the slowing of inflation. One of the main immediate causes behind the drop in CPI growth, the energy prices are ‘no longer pushing up the inflation rate’.

Inflation has dropped to 4.6% in October 2023. Sunak’s primary goal of halving inflation has been reached, and a sigh of relief can be heard from consumers and businesses alike.

What next?

Following what was described as a ‘knife-edge vote’ in September, the BoE has chosen to hold interest rates steady at 5.25%, signalling the end of continuous rises in borrowing costs. Governor Andrew Bailey warned that ‘there is no room for complacency’ even though he believed that inflation ‘would continue to fall’, hinting that the inflation scourge is yet to be over. Bailey was correct; two months later, the 4.6% mark was reached.

Further comments from Bailey warned markets to ‘not underestimate the persistence of inflation’, in response to investors who suspect that the BoE will make their first Bank Rate cut in June 2024. According to the FT, the Bank is ‘downplaying’ CPI growth slowing; they wish to address ‘services prices’ and wages to tackle longer-term causes of inflation. Similarly, Christine Lagarde, chair of the European Central Bank, also did not expect rate cuts for ‘the next couple of quarters’.

The Bank has recently come under fire for being too ‘reluctant’ and ‘complacent’ in their response to the crisis. A House of Lords report suggested that ‘significant reform’ was needed to improve the performance of the Bank, including ‘pruning back’ its responsibilities. Though nobody knows if the Bank could have done better, the inflation crisis has certainly highlighted flaws in our system and provided a genuine moment for the fiscal and monetary to flex their capabilities.

The inflation crisis might be over, but there is a huge metaphorical mess to be cleaned up. By keeping interest rates high, the BoE discourages a reprisal in AD growth by keeping the marginal propensity to save relatively high.

Conclusion

To conclude, inflation has plagued the Covid aftermath almost as badly as the virus itself in 2020. Supply shocks, surging demand and geopolitical events unfolding have left the global economy in a vulnerable position. Responding to sky-high inflation figures, the Bank of England raised interest rates to 5.25%, where they will remain for the foreseeable future. Whether we have weathered the storm or not will soon be made apparent.