Wadsworth Sykes looks at the drivers and impacts of UK inflation, highlighting the risks, outlook for and expectations of a sharp decrease in 2023.
- Pandemic-related supply chain bottlenecks, increased demand for goods and services as the economy recovered, and geopolitical tensions impacting commodities prices, particularly energy are the primary drivers of inflation.
- The persistence of inflation in the UK compared to similar markets will be an ongoing concern for policymakers.
- The relationship between inflation and expectations is critical, we used Datastream to determine the optimal lag between consumer expectations and RPI/CPI.
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The surge in inflation that the United Kingdom experienced during 2021 and 2022 has been a significant challenge for households and policymakers. The primary drivers of inflation have been pandemic-related supply chain bottlenecks, increased demand for goods and services as the economy recovered, and geopolitical tensions impacting commodities prices, particularly energy. As a result, prices for consumer goods and food have increased significantly, with energy prices also experiencing a sharp rise due to cuts in Russian supply.
What is driving inflation?
The impact of the pandemic on supply chains has been a significant factor in driving up inflation. The disruption to global supply chains caused by the pandemic led to shortages in raw materials and components, resulting in higher prices for many goods. Increased demand for goods and services as the economy recovered also contributed to inflationary pressures. This surge in demand was driven in part by the government’s fiscal stimulus measures, including the furlough scheme and the Eat Out to Help Out scheme, which encouraged consumer spending.
Geopolitical tensions, particularly the conflict in Ukraine, have also had an impact on inflation. The energy market has been particularly affected, with the price of domestic gas and electricity increasing significantly due to cuts in Russian supply. This has led to higher energy bills for households, which has added to the overall cost of living.
Driven by residual supply chain bottlenecks caused by the pandemic and strong consumer demand. Food prices also saw a significant increase reaching a 45-year high of 19.1% on an annual basis in March. Additionally, the conflict in Ukraine exasperated energy prices, with the price of domestic gas increasing by over 120% and electricity prices increasing by over 60% due to cuts in Russian supply.
Impact of inflation on households
Despite the increase in consumer spending, the volume of goods sold in the UK has not kept up with the rise in prices, particularly in the case of automotive fuel. This suggests that consumers are reducing their consumption of goods in response to higher prices. The increase in food prices has also led to a reduction in the volume of food consumed since 2021, highlighting the impact of rising prices on consumer behaviour.
One striking trend is the notable difference between the value and volume of goods sold in the UK, with the former outpacing the latter. Highlighting that while consumers may be spending more money, they are not necessarily buying more goods.
The most noticeable differences between the value and volume indices for retail prices in the UK since 2021. The largest difference is in the price vs. volume of automotive fuel which experienced a differential of over 40%. Notably, volume of food consumed has gone down since 2021 while overall prices have increased ~10%.
Europe and inflation
The UK is not alone in experiencing rising inflation over the past year, as the chart below shows. However, the UK is the last of comparable economies to turn the corner. The persistence of inflation in the UK compared to other developed markets will be an ongoing concern for policymakers. It is essential to bring inflation under control to ensure that the cost of living does not become unmanageable for households.
On a positive note, consumers in the United Kingdom are expecting inflations to sharply decrease in the coming year, which could help alleviate concerns about rising prices. The relationship between inflation and expectations is critical, as expectations influence economic behaviour and impact policy effectiveness, in turn affecting actual inflation. Using Datastream’s formula language we determined the optimal lag between consumer expectations and RPI 1 month and 2 months for CPI.
Another indicator that UK Inflation will drop off is the sharp decline in the import prices from the ONS. As producers are charged less for materials one would expect to see this passed onto the consumer.
The Reuters polling average predicts UK inflation to finish at 4.1%, which is quite a bit lower than the BOE’s forecast of 5.3% on an annual basis. The BOE’s forecast comes follows the 12th consecutive rate hike bringing the UK policy rate to a 15-year high at 4.5%.
Looking ahead, we expect inflation to decrease sharply in 2023, driven primarily by the reduction in energy prices and global goods inflation. This reduction should bring inflation below 4% on an annual basis, meeting the target set by Prime Minister Sunak and Chancellor Hunt earlier this year. However, there are risks to this outlook, particularly if there are unexpected commodity shocks, housing deterioration or GBP/EUR weakness.