CPI Inflation, September 2021

We have added the “Very High” scenario to reflect the view that is becoming more widespread that inflation may be taking off from recent historic norms.

In addition, we also have additional “drop ins” resulting from government policy:

a) The reversal of the July 2020 reduction of VAT to only 5% for hospitality, hotel and holiday accommodation and admission to certain attractions.  This reversal will happen in two equal increases of 7.5% at the end of September 2021 and March 2022 returning VAT to the standard rate of 20%.  These two increases will show up in the October 2021 and April 2022 inflation figures.  Using the relevant CPI weights, if all the increase is passed on, the impact on headline inflation could be over 0.5% both times. However, 100% “pass through” is unlikely, and I have opted for 0.3% impact in each of the two months.

b) OFGEM. The increase in the energy price-cap from the end of September will show up in the October 2021 inflation figures. Again, using the relevant CPI weights this gives a likely impact of 0.4%.  There will be another increase to the price-cap in April 2022. Whilst OFGEM will announce this nearer the time, given the behaviour of energy prices in recent months the increase is likely to be of a similar size to the most recent one. Hence, we have added in an additional drop in of 0.4% for April 2022.

The patterns of the medium and high projections are similar, with a big increase in October and November 2021, a fall December 2021, and an increase in April 2022.  After the April peak, inflation heads down and drops to 3.5% in the medium scenario by September 2022. This means that the inflation will remain well above the Bank of England’s target of 2% for some time to come (18-24 months) even if the underlying inflation remains at its historic average as in the medium scenario. In other words, Inflation will remain above 3% for at least 12 months.

However, we have added the very high inflation scenario to reflect an inflationary experience closer to the UK recent average, the 1988-1992 period and current  inflation in the US. In this scenario, inflation heads up to over 6% by April 2022 and remains there until August 2022.  If the supply chain and energy issues persist or get worse, this is the sort of inflationary trajectory we might see. If this trajectory materialiseded, it would imply a complete failure of the Bank of England’s inflation targeting policy and inflationary expectations would almost certainly move away from their historic 2% anchor. However, even under the medium and high scenarios, the behaviour of inflation will pose a challenge for the Bank’s credibility.

Figure 2: Looking forward to August 2022.

Commentary

September saw a slight drop in inflation from 3.1% to 3.2%.  However, this is the calm before the storm and we will see a rapid increase in inflation over the coming 6-7 months to levels not seen for a decade, possibly exceeding 5%.   The drop was expected, as there was a strong base effect contributing a fall of 0.4% to headline inflation. The relief is that the new inflation of 0.3%, although large, was not exceptional and still left us with an overall drop.

If we look back over 2021, there were four months of high monthly inflation between 0.5-0.7%  (March-April, April-May, May-June and July-August), with a brief respite when we saw it drop to zero in June-July.  The new August-September figure of 0.3% is in the 60th percentile, so that whilst above average it is by no means unusual as mom inflation is quite a noisy series. Furthermore, there is a slight positive seasonal effect for September (roughly 0.05%).

The prospects for inflation are now worse than they seemed 6 months ago or even 3 months ago. Of course, even back in April or July, the prospects were very uncertain. This was because of uncertainty about how the imbalance between the supply side and demand side effects of the pandemic and post-pandemic recovery would play out.  Very broadly, the government seems to have dealt with the demand side well, and it is the supply side that has come to dominate in the later months of 2021.  However, a number of factors have meant that the increase in inflation in the closing months of 2021 will be bigger and the period of elevated inflation will last for longer.

1. During the pandemic, there was a shift in expenditure from services to goods. This was in part forced upon consumers during the pandemic and lockdowns, but even as social distancing rules are being relaxed there appears to have been a longer-run shift in expenditure preferences.  This has put great pressures on the more industrialised countries to meet this higher demand and within countries their manufacturing sectors.  It remains to be seen how persistent this shift in preferences is and whether expenditure patterns will eventually revert to their pre-pandemic pattern or more likely move to some degree of permanent shift to a new post pandemic normal.
2. The labour market has been slow to adjust to the rapid changes. Labour shortages have appeared across the globe and are very acute in the UK. Again, this is in part a change in preferences. Workers may have decided to adjust their work-life balance, be more reluctant to commute, be unwilling to change job. There is also the shift in employment demand resulting from the shift in expenditure patterns. In normal times there are usually lags and “adjustment costs” that go along with this sort of change in the labour market. Post pandemic, these standard processes of adjustment have become larger and faster, with the labour market and firms having difficulty to cope with these big adjustments. In the UK, the furlough scheme kept people out of the labour market and whilst it may have protected jobs, it has also slowed up labour market adjustment in its later phase.
3. Wages and salaries. These have proven hard to track during the pandemic due to composition effects (the average rose because lower paid jobs were most affected during the pandemic). The existence of labour shortages persisting may well reflect a mis-match between skills needed and current skills and worker preferences , which may lead to a general increase in wages reinforced by the rising inflation. If this happens, then we will have the positive feedback between wage and price inflation which could lead to an increase in the underlying or “trend” inflation from its historic anchor of 2%.
4. The rapid increase in energy prices which are now in the headlines. There is a world imbalance and general excess demand for energy. There are various reasons for this, from the bad winter last year to the lack of wind in Europe. In the UK, electricity and Gas prices are both well above any previous historical values, even their peak in 2008. Oil has also gone up, but is still below its historic highs of 2011-13.  The Ofgem price cap is changed every six months, on October 1st and April 1st, entering the ONS inflation figures for those months. The big increases in 2021 at these dates seem likely to be repeated at least for April 1st 2022.
5. Supply chain shortages have lasted longer than previously thought. Rather than a temporary re-adjustment as the pandemic ended, they have if anything continued to intensify and show little sign of abating in the near future.  From seagoing container shipping to lorries, the transportation issues have become worse over time and resulted in delays and increased costs in moving goods around the world and within the UK.  Of course, everything in the national and global economy is linked by the web of the Leontief inverse and shortages in one sector or service can affect lots of other sectors either directly or indirectly. How and when these supply chain issues will eventually start to ease is still a matter of considerable uncertainty and things are currently still getting worse rather than better.

The fact that inflation will probably remain well above the Bank of England’s target for the next 18-24 months might raise serious questions about continuing the Banks policy since 2009 of leaving interest rates fixed at near zero levels.  Expectations of underlying inflation may start to rise, which would cause serious challenges for monetary policy going forward.

For further analysis of current and future prospects for inflation in the UK see:

NIESR CPI Tracker

Will Inflation take off in the UK? The Economics Observatory.

UK Economic Outlook Summer 2021: Emerging from the Shadow of Covid-19.