Why is UK inflation still so high?

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My question this month is “why is UK inflation still so high?”

Last week came with a tedious sense of déjà vu. Once again, UK inflation was expected to finally retreat below 10%. And once again, it did not.

The impact was felt most clearly in UK markets. The bond market repriced as expectations of a further 25 basis point hike from the Bank of England in May firmed. Ten-year Gilts lost nearly 2% over the week of the inflation release. But the higher-than-expected print also sent tremors through global bond markets as investors questioned – once again – whether the inflation problem is definitively behind us.?

So what is going on? The table below provides some clues.?

Table 1: Inflation contributions

% change year on year; contributions are % points

Let’s start with the (somewhat) positive. Energy and food are still adding a lot to UK inflation, but their impact in other regions has started to diminish. Some of the UK’s lag is merely timing. Higher energy prices contributed 3 percentage points to headline inflation in the US back in June 2022, but now detract from the overall figure.

In both the UK and eurozone, the energy contribution was bigger and more prolonged than in the US because of Europe’s dependence on gas and the spike in wholesale prices after Russia’s invasion of Ukraine. Gas prices have since moderated, which has been passed through to end consumers more quickly in certain eurozone countries than the UK, which moves in a more step-like fashion thanks to its regulated energy price cap.

But this merely delays the inevitable, and over the coming months headline inflation will fall as the UK benefits from more favourable base effects for energy.

Food price inflation has been relatively similar in the UK and eurozone. If prices soon stabilise – as global food indices suggest they should – then this contribution will drop out, and that should shave 1 percentage point off inflation in the coming months.

We’re also reasonably optimistic core goods inflation will moderate. Supply chain pressures have eased globally and demand for goods is also moderating, which should make producers more hesitant about pushing for sizeable price gains from here.

We’re less confident, however, that service sector inflation will moderate meaningfully from here. This is where the UK story gets concerning, thanks to what appear to be more structural problems in labour supply.

The UK labour market seems to have suffered more lasting damage from the pandemic. Participation fell everywhere in the pandemic but has recovered entirely in the eurozone, unlike in the UK. This may be a timing effect, and the higher cost of living may eventually tempt people back to work. But unlike elsewhere, since early 2020 an extra 400,000 working-age people have stated that they are economically inactive due to long-term health issues – a rise of 20%. These people may be unable to return to the work force.?

Chart 1: Job vacancies relative to unemployed

x, multiple

With vacancies far outstripping the number of unemployed (Chart 1), workers are feeling emboldened to ask for more pay (Chart 2), to at least partially compensate for the rising cost of living. Of course, for companies in which wage costs make up a large part of overall costs, this puts further upward pressure on input prices. This is the wage-price spiral that proved so damaging in the 1970s.??

Chart 2: Wage growth

% change year on year

Chart 3 shows our expectations for inflation to the end of the year, broken down into contributing factors. UK inflation is expected to fall and indeed if energy and food prices stabilise could step down quite significantly when the April data are released on May 24. But it will likely remain uncomfortably above the Bank of England’s 2% target. The Bank is therefore in the unfortunate position of needing to generate a weaker economy. It needs to create uncertainty and fragility so that workers stop asking for higher pay and firms stop asking for higher prices. We see a further rate hike in May to 4.5%, and believe it is likely that UK interest rates will reach 5% before the year ends.

Chart 3: Our expectations for UK inflation

% change year on year

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