After a holiday from the worried minds of economists and central bankers, inflation is once again the topic de jour. Soaring commodity prices, notably oil and gas, in addition to labour market mismatches and disrupted supply chains are putting pressure on prices. Inflation is now forecast to peak at 4.4 per cent in the second quarter of 2022, 2.6 percentage points higher than forecast in March 2021. Shortages of semiconductor chips and ships in the right places have also appeared. Doomsayers envision a “return to the 1970s”, a period during which a loveless marriage between high inflation and stagnant growth (often referred to as “stagflation”) arrested the steadfast growth in post-war living standards and incubated Thatcher’s rise to power. Such thinking however, rests upon an understanding of inflation existing either at very low, or very high, levels, and is remiss of the space in between. The UK is not going to return to the Winter of Discontent. Instead, it is more likely that it will enter a new epoch of monetary policy, in which slightly higher inflation is tolerated.
It is important to note that much of the UK’s inflationary pressure stems from transitionary sources and not from a systemic supply-demand asymmetry.
Labour market mismatches should fade as firms recruit and train new staff – at higher wages for some. And higher prices naturally cause people to economise, which will force prices down. Labour unions, in large part because of the 1970s, are much diminished in their capacity to determine wages. This reduces the threat of wage inflation. Commodity prices, remember, are famously cyclical and extremely exposed to an unexpected period of depressed economic activity – such as, crucially, the reintroduction of COVID containment measures in response to a new variant. Biden’s infrastructure bill reduces the threat of this in the US, but the same is not true here. This is further made true by the growth of Sunak’s fiscal conservatism in Johnson’s mind. Supply chain disruptions with begin to subside as COVID restrictions subside and ports have more universal regulations. Perhaps most of all, the UK has an extremely robust monetary armoury that is equipped to respond to a dangerous rise in inflation. Interest rates are currently at a record low of 0.1%. There is plenty of headroom for an increase. And, in fact, some other developments will reduce inflation. The £20 a week cut in Universal Credit will cut aggregate demand and, at the margin, therefore help force down inflation.
It is only if rising prices lead to higher inflation expectations and hence to further price rises that inflation will become entrenched. So far, though, there is little firm evidence of this. Indeed, the greater risk is running the economy too cool rather than too hot – as was the case in response to the financial crisis. The currently unusually intense pressure on prices will cool, and whilst the epoch of sub 2% inflation may be over, its successor will not match the apocalyptic expectations of the most pessimistic.