Where now for inflation and interest rates?

High inflation is the biggest threat to growth as the UK sees early signs of recovery. But how worried should we be? Is it transitory or a longer term risk, and is it a global or local issue?

The UK consumer price inflation reached 4.2% in October 2021, a significant increase from the 0.6% recorded in December 2020. This is rapidly approaching the 5.1% recorded in September 2008 and again in October 2011. Almost all economies are experiencing high inflation. USA inflation was 6.2% in October, and Eurozone inflation reached 4.9% in November – the highest reading since the creation of the Euro. 

This suggests that the current spate of high inflation is a global phenomenon not specific to the UK. Global supply chain disruption has meant that supply has not kept up with rapid economic recovery, causing prices to rise in some sectors. In addition, energy prices have increased markedly, contributing heavily to high headline inflation numbers reported by the media.

This is supported by analysis from the ONS, which shows that the increase in UK inflation is due almost entirely to an acceleration of inflation in energy products and other goods with a high import content. There are examples of domestically generated increases in inflation, such as in hotels and restaurants, but these are the exceptions and not the rule. The same is true for cost increases due to Brexit-related labour shortages that are specific to a few sectors and not a primary driver of inflation.

The prognosis is for even higher inflation for the next few months, but what then? Commodity prices are already coming down. World oil prices fell 20% over the past three weeks, primarily because of the Omicron scare. They could recover if the uncertainty fades, but the big adjustment will come when the expected supply increases materialise. The other fear among policymakers is a 1970’s style wage-price spiral. However, given today’s labour and product markets are much more competitive than they were, the prospect of a wage-price spiral is far less likely. All of this suggests that inflation is most likely to head back towards the 2% target by this time next year, and it may even go below it in 2023.

There are risks. De-carbonisation could add a new twist to energy prices, and the great resignation could change labour markets. Omicron or a new wave of Delta may slow the switch from consumer goods to services, a much-needed rebalancing that will help ease supply chain pressures. On balance, even though it may feel that we are in the eye of the storm, we think the evidence is already there for temporary rather than persistent inflation.

High inflation has led to an increasing clamour for a rise in interest rates. Omicron has put an end to the chance of an increase in Bank Rate this side of Christmas, but a move is almost certain next year. Long-term government bond yields will increase, Omicron permitting, but the driver will be signs that economic recovery is established. This will allow central banks to go through with monetary policy normalisation, so we see government bond yields increasing as inflation recedes in the second half of next year – but to something like pre-pandemic not pre-GFC levels.