First, the good news. Inflation is heading lower. US inflation peaked at 8.5 per cent late last year and is now running at around five per cent. Eurozone inflation peaked at 10.6 per cent and is now down to 6.1 per cent. UK inflation peaked at more than 11 per cent and has dropped to 8.7 per cent.
Second, the not so good news. Although inflation in all three economies is lower than it was, prices are still rising too quickly. Remember, the Federal Reserve, the European Central Bank and the Bank of England are supposed to bring inflation back down to two per cent and, generally speaking, keep it there. As yet, not one of these central banks is close, one reason why financial markets think interest rates may still be heading higher.
Third, the very bad news — at least from the UK’s perspective. To avoid being fooled by the more volatile aspects of inflation (food and energy prices, most obviously, which have a habit of jumping all over the place) policymakers often focus on so-called “core” inflation, stripping out the “bumpier” components. Measured this way, US inflation is running at 5.5 per cent and eurozone inflation is at 5.3 per cent. UK inflation, however, is at 6.8 per cent. Worse, even as core inflation has either flatlined or fallen elsewhere, it’s still heading higher in the UK. April’s outcome was the highest “core” inflation reading since March 1992, five years before the Bank of England was granted its operational independence.
Inflation everywhere is higher than it should be, but the UK’s inflation rate is particularly bad. And the Bank of England doesn’t really know why. Andrew Bailey, the Bank’s Governor, admitted in front of Parliament’s Treasury Committee the other day that the Bank’s inflation “model” hasn’t been working well. This, however, was the model which persuaded the Bank that the inflation shocks associated with the pandemic and Russia’s invasion of Ukraine would have temporary effects.
Yes, UK interest rates have risen a lot over the last 18 months but, given its failure to spot so-called “second-round effects”, was the Bank too cautious in applying the monetary brakes (even if it was one of the first to put its foot on the brake pedal)? After all, there have been more interest rate increases in the US and inflation there is now much lower than it is here.
There is, however, a rather obvious problem with this argument. Yes, the Fed has raised interest rates more than the Bank but the Old Lady has raised interest rates sooner and by more than the European Central Bank. Inflation across the Channel, however, is also lower than it is at home. Something else is afoot.
Chris Hare, my colleague at HSBC, has given considerable thought to this inflationary puzzle. One issue is labour shortages, partly associated with the lasting effects of Brexit. Yes, immigration in the last year or so has been very high — if the data are to be believed – but the nature of immigration has changed. We have welcomed Ukrainians fleeing the terrors inflicted on their country alongside more students, but fewer of the lower-skilled workers from the EU who, previously, were the lifeblood of our retail and hospitality industries. One consequence has been larger hotel and restaurant price increases in the UK compared with those seen in the eurozone or the US.
A second issue is the huge increase in the number of those designated “long-term sick”. At the last count, half a million people had left the UK labour force compared with levels before the onset of the pandemic. The odd thing here, of course, is that Covid was — and is — far from being a uniquely British experience. Perhaps, however, the UK was poorly positioned to cope. One statistic, from the British Medical Association, is startling: 362,500 people have been waiting for more than a year for treatment, 169 times higher than in February 2020 when a little-known disease circulating in Wuhan was mostly regarded as a problem happening “over there” rather than “over here”.
Solving the UK’s inflation problem is, therefore, easy. Simply reverse Brexit to deal with labour shortages and, separately, pay for a hugely expanded NHS. As neither, however, will be happening any time soon, the Bank of England will be left to pick up the inflationary pieces. The only treatment many of us will receive is tough monetary medicine.
Stephen King (@kingeconomist) is HSBC’s Senior Economic Adviser and author of We Need to Talk About Inflation
