UK Economic Outlook Autumn 2021 (Inflation)

Why is higher inflation concerning?

During 2021 inflation exploded, with the inflation rate rising from 0.4% in February to 4.2% in October, with inflation expected to peak at around 5% by April 2022. 

The effect of higher inflation on households is usually twofold. Firstly, faced with rising production costs, producers will tend to pass on these extra costs to the final consumer, resulting in higher end-product costs. Inflation also reduces households real income and therefore their purchasing power. 

What are the key things driving inflation?

There are several factors working in tandem driving inflation, however, most of these factors can be traced back to the COVID-19 Pandemic. 

The first factor is supply constraints. During 2020 output collapsed, consumers stopped spending and businesses scaled back operations to save money. With the recovery from the pandemic, businesses are now struggling to re-increase their output capacity fast enough to cope with the new rise in demand. They need to increase recruitment, purchase more input products and reorganise themselves, at a time when the pandemic is still imposing restraints on all of us, which leads to higher costs. 

Another factor is the surge in energy prices. The gas crisis in Europe is an example of this. Rising demand for energy means higher prices are here to stay. Higher energy prices increase inflation because energy is necessary both for any production activities and for households to heat and power their homes. 

Surging transport costs have also boosted inflation. With changing consumption patterns consumers are purchasing more goods from home and fewer services. This situation has made it a challenge for firms to produce and deliver the extra goods. The cost of shipping from Asia to North Europe has risen by more than 600% between 2020-2021 and air cargo is at full capacity. 

What is the Bank of England doing about it?

With inflation expected to reach 5% by mid-2022, more than twice the Bank of England target of 2%, Cyrille argues that the Bank of England should have raised rates already.

The MPC surprised markets in November 2021 by not raising interest rates, despite it being suggested in the run-up to the meeting. The reasoning behind this is that the MPC argues that the forces behind the current surge in inflation are transitory and that they will disappear soon. However, they are still implying a rate hike soon.