Why is UK inflation so high?

15 May 2023

Inflation has fallen sharply in the US and in the euro area in recent months. In the UK it is stuck at 10.1%, only down marginally from its peak and twice US levels. We are frequently asked why this is. This week’s briefing offers a degree of reassurance. It looks as if the inflation gap is about to narrow.

High UK inflation is partly due to Britain’s reliance on natural gas whose wholesale price rose 14-fold between early 2021 and last summer’s peak. Prices have since tumbled but are still more than three times above what was considered a normal level before the pandemic.

Gas plays a far bigger role in the energy mix in the UK than in the US or Europe. 85% of UK households have gas boilers, less than half of EU households do. Gas accounts for 40% of UK electricity and 20% of EU electricity. Standards of insulation tend to be higher in the EU than in the UK.

Differences in the way in which higher wholesale gas prices are passed on to consumers have also played a role in sustaining UK inflation.

At the onset of the energy crisis household energy prices spiked a couple of months earlier in the EU than in the UK reflecting different mechanisms for setting consumer bills. Just as the feed through to bills was faster in the EU, so too has been the feed through of falling wholesale prices to EU consumers.

The UK government initially took the view that the best way to deal with the shock of higher energy prices was to pass on increased costs and give targeted support to low-income consumers. Some other euro area countries, including the Netherlands, took a similar approach, while others opted to cap prices. France, for instance, limited electricity price rises to 4% and froze domestic gas prices, with difference covered by public subsidies. But with increases in wholesale gas prices far exceeding expectations, the UK changed tack in October 2022 and introduced a general subsidy, the Energy Price Guarantee (EPG). The UK’s later embrace of the EPG, initially opting instead for subsidies, meant that UK households experienced higher energy prices at the start of the crisis than the euro area average.

So higher gas use, lags and subsidies have all played a role in keeping UK inflation at double-digit levels. Things are, however, about to change. April’s UK inflation data, due to be released later this month, is likely to show the headline rate dropping from 10.1% to around 8.0% as the effects of higher gas prices in early 2022 fall out of the calculation. Headline inflation will fall still further in subsequent months as lower wholesale prices feed through to household bills.

The Bank of England last week raised its forecast for UK inflation, partly as a result of more resilient growth and easier fiscal policy. Nonetheless, the Bank sees inflation dropping to just over 5.0% at the end of this year and falling further in 2024.

While energy has played an outsize role in sustaining UK inflation, it is not the only factor. Stripping out energy prices, so-called core inflation is running at rather higher levels in the UK than in the EU or the US. There are several potential explanations for this gap.

The UK is facing what the governor of the Bank of England, Andrew Bailey, has described as a unique “labour force shock” due to a surge in early retirement and long-term sickness. Between late 2019 and mid 2022, the number of working-age people who were outside the labour force, due to early retirement, sickness or studying, rose by around 800,000 people. This shrinkage of the workforce, which is unique among major industrialised economies, is likely to have contributed to wage and inflation pressures. Brexit has also played a role. It has contributed to higher import costs, a weaker pound and has dampened levels of investment. These effects are, however, likely to moderate with time.

UK inflation should fall more sharply through the rest of this year as lower energy prices feed through, with the annual rate more than halving by December. That is the easy part. Even if inflation drops to around 4.0% at the start of 2024, it will still be running at twice the Bank of England’s target rate. Lower energy prices will make a big difference, but there is a long way to go before inflation hits anything approximating normal levels.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week up 0.7% at 7,755.

Economics

On Saturday, US treasury secretary Janet Yellen said Republicans and Democrats had found some areas of agreement in their negotiations on the US debt ceiling. Ms Yellen has previously warned that the US might be unable to pay its bills as early as 1 June
The Bank of England raised its benchmark interest rate by 25 basis points to 4.5% and now expects inflation to stay higher for longer
The Bank of England reported a marked improvement in its economic forecast, expecting the UK economy to grow by 0.4% in 2023
UK GDP grew by 0.1% in Q1 2023 with services output weighing on growth in February and March
US inflation fell for the tenth consecutive month to 4.9% in April, increasing the chances of a pause in the Federal Reserve’s hiking cycle
US consumer sentiment fell to its lowest level this year as households worry about the state of the US economy
The Fed’s Financial Stability Report highlighted the risk of recent stress in US regional banks fuelling a credit crunch and resulting in an economic slowdown
UK house prices fell by 0.3% over April after recovering in the previous three months, according to Halifax
The Resolution Foundation think tank warned that two-thirds of the £12bn total increase in UK mortgage costs from higher interest rates have yet to be passed on to borrowers
Euro area consumer inflation expectations over the next 12 months jumped from 4.6% to 5% in May
Global luxury house prices fell in Q1 2023 for the first time since 2009 as rising interest rates hit demand
US crude oil inventories rose by 3.6m barrels last week in a possible sign of weakening demand, according to the American Petroleum Institute
EU population declined by more than half a million from 2020 to 2022, with Italy suffering the largest decline

Business

US regional bank PacWest Bancorp reported a further decline in weekly deposits, pointing to additional banking stress
Google launched a generative AI-powered search engine to rival Microsoft’s Bing search
Airbnb shares suffered a sharp drop last week as the platform warned of a slowdown in bookings in Q2 2023 in a sign of a slowdown in the travel industry
Luxury travel is reported to be spearheading the recovery in the airline sector as first-class and business-class flight bookings boom
Brookfield CEO Bruce Flatt warned of consolidations in the private equity industry following a tough year for smaller players in the sector
Novavax announced a 50% cut to annual spending and 25% job cuts as demand dwindles for its COVID-19 vaccine
Saudi oil group Aramco posted a 19% drop in profits in Q1 2023 following lower than anticipated oil prices

Global and political developments

The UK delivered longer-range Storm Shadow missiles to Ukraine
The US authorised the first transfer of assets from a sanctioned Russian oligarch to help Ukraine’s reconstruction efforts
The UK government scrapped plans to revoke all EU-derived legislation
EU parliamentary commissions proposed legislation to ban most facial recognition technologies in surveillance and predictive policing, as well as impose controls on general-purpose AI
China reported that a long-awaited meeting with the US defence secretary will not go ahead, as tensions between the two countries remain high

And finally… North Carolina police arrested a man for reckless driving after a high-speed chase. The suspect, who fled on foot into nearby fields, was located thanks to cows that led police to his hiding spot - udder-cover work

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