Reading the runes on UK inflation

It would be easy to get “sticker shock” from the latest UK price data, released earlier this week. The figures, from the Office for National Statistics, show that the rate of inflation reached 4.2 per cent in October, the highest rate since 2011 and more than double the Bank of England’s two per cent target. For many, that on its own is enough to conclude that the central bank erred in failing to raise rates as many investors anticipated it would at its November meeting.

Monetary policy has, however, in the words of the economist Milton Friedman “long and variable lags”: it can take a while, often more than a year, for changes in interest rates to affect economic growth and the rate of price growth. The challenge facing central bankers is how to use the data they receive about the present state of the economy to judge the future needs of the economy.

On that subject the details of the latest inflation data are less clear. Much of the sharp increase is due to factors that are unlikely to be repeated and will, almost certainly, fade away by this time next year. The largest contribution comes from a surge in natural gas prices and other energy costs. The ONS estimates that roughly 1.3 percentage points of the year-on-year increase in the consumer price index is due to higher fuel costs. Used car prices and higher air fares, following the resumption of plane travel, made transport the second biggest contributor. Higher hospitality prices, partly thanks to the removal of a temporary value added tax cut for the sector, were the third.

Unlike in the US, there is only scant evidence of an economy at risk of overheating from too much monetary and fiscal stimulus. Only a few categories of goods hint at an economy with an excess of demand relative to supply: furniture prices have surged, probably owing to more affluent households spending some of their pandemic savings on redecorating, as have the costs of household appliances. Elsewhere, however, price growth is more modest.

On the other hand, there is little reason to think that the economy is still in need of the stimulus launched during the depths of the pandemic. Labour market data, published earlier this month, demonstrated that the end of the “furlough” job retention scheme has not slowed the recovery in employment. Bank of England officials have said that uncertainty over the impact of the end of the programme was a major reason why the central bank’s rate-setting committee held off on raising interest rates in November.

For the moment there is little sign of any feared “wage-price spiral” in the data — a situation where rising labour costs add to inflationary pressure as employees try to maintain their purchasing power in the face of rising prices. Pandemic-related distortions make headline pay figures less reliable but it is likely that wage growth has now dropped below inflation. Indeed figures from research group XpertHR indicate that the median settlement is stuck around the pre-pandemic norm of 2 per cent.

Nevertheless, more workers are quitting to find new jobs and advertised vacancies are at a record high. These are all a sign of a labour market that could soon be “tight” enough to provoke sustained pay increases. In such circumstances there is little reason to think the UK still needs as much central bank support as it once did.

Before the November meeting of the Bank of England’s monetary policy committee, this newspaper argued that the case for a rate rise was finely balanced. While the surge in inflation is not as worrying as it may first appear, the labour market data does put more pressure on the BoE to act in December.

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