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Inflation risks and labour market frictions weigh heavy on UK’s economic recovery
Escalating inflation in the UK economy reached a decade-long high in October, as higher energy prices, supply chain disruptions, labour shortages, wage and food price inflation all blunted the economic recovery.
Inflationary pressures are proving stickier than the Bank of England’s (BoE) ‘transitory’ narrative implied. Demand in certain sectors remains strong, while a range of costs are all under upward pressure, from gas and electricity to transport and housing. In the hospitality and tourism sector, VAT returned to 12.5%. Labour and materials shortages compound the inflationary effects. Taken together, these rising costs pushed up the annual rate of the consumer price index (CPI) to 4.2% in October, new Office for National Statistics (ONS) data published on Wednesday morning shows. CPI inflation is forecast to climb to reach 4.5% in the 12 months to November, hovering around that level through the winter, and peak at 5% in April 2022, more than double than the Bank’s 2% target.
The hot inflation print follows strong labour market data. UK employment numbers climbed 160,000 in October to 29.3 million, implying furloughed workers returned to their jobs after the expiry of the Coronavirus Job Retention Scheme in September. This is consistent with earlier anecdotal ONS survey data, which showed around 85% of the 1.1 million people who came off furlough support returned to work. The labour market, beset by an overall shortage of workers and a skills gap which is driving up wages, will be a crucial determinant for the timing and pace of the Bank’s rate decisions. Unchecked labour market frictions could risk inflation broadening out across the economy. The unemployment rate fell to 4.5% in the three months to August, which may rise slightly in Q4.
Rising inflation and a recovering labour market will likely give the Bank the evidence it requires to finally increase interest rates, now expected next month, which would see the UK as the first major economy to lift borrowing costs since the onset of the pandemic. Markets are pricing in combined rate increases of around 115 basis points over the next 18 months. But it is a difficult balance for the Bank as higher base rates will blunt an already weakening outlook for GDP. If the Bank increases interest rates too fast, the danger is in slowing already moderating GDP growth. However, if the Bank leaves inflation unchecked, the UK economy could start to run too hot, blunting consumer spending and real incomes in the coming quarters. At the same time, higher taxes (i.e. the health and social care levy and dividend income tax increases) and reduced monetary and fiscal policy support will also temper future demand growth.
Current ONS data paints a contradictory GDP picture. Two separate ONS datasets, both purporting to measure UK economic activity, appear to show opposite findings. In one measurement, based on the quarterly data, UK economic output expanded by 1.3% in Q3, still 2.1% below pre-pandemic levels, which should fully recover in Q1. But the monthly data implies the UK economy was just 0.6% below pre-pandemic levels at the end of September. Based on implied monthly growth trend rates, the remaining ground has likely already caught up in the intervening six weeks.
The ONS says the divergence is the result of statistical measurement challenges caused by the pandemic. So, which is it? The UK economy is either some way off pre-pandemic economic parity or has already caught up. The discrepancy matters. The data has implications for the timing and pace of the Bank’s interest rates decisions and government borrowing projections by the Office for Budget Responsibility’s (OBR), as well as a raft of decisions by policymakers and corporates on business investment and job creation. It also affects assessments of the UK’s recovery relative to other economies around the world.
On balance, the quarterly data probably is more reliable. It is the dataset cited by the Bank in its Monetary Policy Report. The Bank forecasts a 1.0% increase for GDP in Q4, leaving the UK economy 0.9% below its pre-pandemic level, with the pace of economic growth slowing as inflationary pressures blunt momentum. However, the Bank maintains that inflation will dissipate over time as supply disruptions are expected to ease, global demand rebalances, and energy prices will stop rising.
The Bank’s Monetary Policy Committee (MPC) maintained current interest rates at its early November meeting, noting a slowing economic recovery as supply chain bottlenecks stifle productivity. Looking ahead, the UK economy has entered a new and challenging phase of its economic recovery since the onset of the pandemic almost two years ago.
Demand will soften as inflationary pressures, waning effects of policy stimulus and higher energy prices blunt consumer confidence and household spending. These pressures are common throughout the major Western economies in Europe and the US – with the rate of UK inflation between the US and the eurozone, reinforcing a sluggish outlook for global growth.
The UK outlook has at least one more idiosyncratic risk with rising speculation that the UK may trigger Article 16 of the Northern Ireland Protocol, adding uncertainty to the UK’s outlook for EU trade as well as the more alarming prospect of jeopardising the whole UK/EU Brexit deal. It could indeed be a difficult winter.