Has UK inflation already peaked?

After a long period where almost everyone has been too complacent about inflation, the tide may finally be about to turn. Inflation is now set to peak sooner and fall faster than many expect – even in ‘Brexit Britain’.

Admittedly, this is partly a reflection of just how far inflation has already risen. The headline measure of UK consumer price inflation hit 9 per cent in April. It is widely predicted to climb even further in the autumn, when the Ofgem price cap on domestic energy bills is updated. The alternative RPI measure is already above 11 per cent.

Other countries have also seen sharp rises in the cost of living. Inflation is now above 8 per cent in both the US and the euro area. Within the EU, inflation is around 10 per cent in Belgium and the Netherlands. The average across all members of the OECD in April was 9.2 per cent.

What next? In order to predict the future we need to understand how we got here. There are three parts to this puzzle: the strength of demand, shocks on the supply side, and the role of monetary policy. The third of these is often neglected, but potentially most important.

The strength of demand has at least been a ‘good news’ story. It seems an age ago now, but remember that the global economy – and the UK in particular – rebounded more quickly than anticipated from the pandemic, helped by the successful rollout of the vaccines.

Central banks under-estimated the resulting demand-pull inflation, partly because they were expecting a much weaker recovery. But they also relied too much on simple ‘output gap’ models that assumed inflation would remain subdued as long as the overall level of economic activity was still far below its pre-Covid trend. This gave too little weight to the dislocation of activity and the heightened pressures in sectors that were still open.

Supply shocks have played an increasing part, as well. Even before the latest invasion of Ukraine, supply chain problems and labour shortages were adding to cost-push inflation. The Russian aggression has exacerbated these pressures, particular in commodity markets – from energy and metals to agricultural products, including wheat and vegetable oils.

Finally, all of this has been facilitated by a long period of excessively loose monetary policy, with the US Fed, European Central Bank and the Bank of England all continuing to pump huge amounts of money into economies that were already overheating.

This part of the explanation for higher inflation is crucial and often missing. Without this additional monetary stimulus, higher inflation for the goods and services in short supply would have been offset by lower inflation elsewhere. The loss of credibility has not helped either, because of its impact on inflation expectations.

However, there are now reasons for optimism on all three fronts. The global economy is slowing and, while this is a ‘bad news’ story in other respects, it will at least ease some of the demand-pull pressures.

More positively, the supply-side pressures may also be fading. Part of the cure here is simply the passage of time. Prices have now been high for many months, providing both the incentive and the opportunity for consumers to find alternative sources, and for producers to increase their output. Higher wages are part of the solution to labour shortages, too.

Indeed, there are already some tentative signs in commodity markets and in business surveys that prices are levelling out, that supply disruptions are starting to ease, and that input cost pressures are peaking. The recent lifting of Covid restrictions in China will also help.

And even if prices simply stabilise at current high levels, the headline rates of inflation will fall sharply as the previous big increases drop out of the annual comparison.

Thirdly, central banks are finally waking up and starting to withdraw some of the exceptional monetary stimulus. The focus here is usually on official interest rates, even though these remain so low that further increases are unlikely to make much difference.

The more important change is actually the sharp deceleration in the growth of the money supply. This had led some leading monetarists to worry that central banks might be hitting the brakes too hard, but there is still a large overhang from the previous period of rapid monetary expansion.

This has a ‘real world’ counterpart in the build up of household savings during the pandemic, which some at least will be able to use to maintain spending despite a tight squeeze on real incomes.

With a bit of luck, the sharp deceleration in monetary growth should therefore be enough to deliver a soft landing for inflation, without tipping the economy into recession.

In summary, the current burst of global inflation should indeed prove to be temporary – even though it has been far more persistent than most had anticipated. This was pay back for all the extra money injected under the policy of ‘quantitative easing’, but the era of ‘quantitative tightening’ has now begun.

Of course, the precise monthly profiles for inflation in individual countries will also depend on local factors. The base effects in the annual comparison are relatively favourable in the US, which should see the fastest declines in the headline rate in the coming months.

The UK may be a laggard, depending in part on what happens to the energy price cap in the autumn. The official statisticians also still need to decide whether to treat the new £400 discount as a price cut, or just a transfer payment from the government to consumers.

Nonetheless, I am now ready to stick my neck out again and predict that the consumer price measure of inflation has already peaked, at around 9%. By the middle of next year, it should be back down close to the 2% target again in the UK too.

This piece was first published in the Daily Telegraph on 3rd June 2022

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