The whiff of inflation is in the air. In the US, the headline measure of inflation has risen to 5 per cent. The price of goods leaving US factories is up 6.6 per cent. In the Eurozone, CPI inflation has risen from negative territory last autumn to around 2 per cent now. Factory gate prices in the euro area are nearly 10 per cent up on a year ago.
Here in the UK, inflation has risen to 2.1 per cent—just above the Bank of England’s target. But there are many indications it will rise further. As in the US and the Eurozone, manufactured goods prices are rising more rapidly—up 4.6 per cent on a year ago. In addition, the cost of goods purchased by UK manufacturers is up 10.7 per cent on last year. This indicates that more inflationary pressure is in the pipeline.
So how worried should we be about a prolonged surge in inflation across the major western economies? And how should central banks respond?
Four main factors appear to be driving this inflationary surge.
First, the lockdowns we saw last year and earlier this year are being unwound. As a result, the depressing effect that these lockdowns had on prices is also unwinding. This phenomenon should prove temporary, unless it sparks a more general wage-price spiral. However, this surge in inflation may have further to run, as measures taken to help businesses during the pandemic crisis are removed.
The UK has implemented a VAT reduction in the hospitality sector. That has helped keep down consumer prices since last summer, but that effect on the year-on-year inflation will wear off by August, pushing up the headline rate. In addition, if the Chancellor of the Exchequer reverses this tax reduction later in the year, returning the normal VAT rate to 20 per cent, that could boost inflation by a further 1-1.5 per cent. These VAT effects alone have the potential to raise the UK CPI inflation rate to 4-5 per cent by the end of this year.
Second, oil and commodity prices have been rising. The price of oil (Brent crude) is now around $75/barrel, up from around $40 a year ago. The Economist’s dollar index of commodity prices is 70 per cent up on the year before. These energy and commodity price rises will take a while to feed through supply chains to consumers, so again we should expect to see further headline inflation increases from this direction as we move through this year and into 2022.
Third, economic growth is bouncing back, which gives businesses the opportunity to pass through price rises to consumers and recoup losses they might have incurred earlier in the pandemic. We are still in the early stages of this global economic recovery, but the IMF is forecasting 6 per cent world GDP growth this year and around 4.5 per cent next year. Forecasts for some individual economies are higher than this. For example, the UK economy is now widely expected to grow by around 7 per cent this year and about 5.5 per cent in 2022.
Finally, there are likely to be longer-term effects from the pandemic crisis which could result in elevated costs and reduced productivity for a number of years. The IMF now estimates that, despite the projected recovery, global GDP in 2024/25 is likely to be 3-4 per cent lower than it had expected before the pandemic. Many businesses—particularly in hard-hit sectors like hospitality and travel—may be looking to recoup the effects of higher costs and lower productivity through price rises over the years ahead.
It is clear some of these effects will have a temporary impact on inflation—but others may be longer lasting. That risk will be higher if we get a second-round impact on wages following the current inflation surge. Businesses in some sectors, such as construction, are starting to report a skills shortage. In the UK, the unfilled vacancy rate has already bounced back to around the levels we were seeing before the crisis, in 2018 and 2019.
How should central banks respond to this situation? So far, they are adopting a “wait and see” approach. In the US, the Federal Reserve is not expected to raise interest rates until 2022 or 2023, and the Bank of England and the European Central Bank have given little indication that they are about to remove monetary stimulus.
Central banks are right to resist a knee-jerk monetary policy response. But they need to recognise the risk of a more sustained rise in inflation in the years ahead. Also, both monetary and fiscal policy have been used to provide a lot of economic stimulus over the past 18 months. A policy of starting to gradually unwind some of this monetary stimulus makes good practical sense.
If I were still a member of the Bank of England Monetary Policy Committee, I would be arguing for this process of withdrawing stimulus to start in the next few months—with an end to Quantitative Easing asset purchases and a small rise in the official Bank Rate from 0.1 per cent to 0.25 per cent, with an indication of more gradual interest rate rises to come over the next 12-18 months.
Any gradual withdrawal of monetary stimulus should be conditional on the economy continuing to recover and employment picking up as lockdown restrictions are eased. The great advantage of monetary policy is that it is a flexible tool. Therefore, the pace and extent of any policy action can be adjusted in the light of how economies are performing in the post-pandemic “new normal.”
