Core inflation in the UK, which excludes volatile items such as energy and food, peaked in May at 7.1% – later and a little higher than in the US and some other high-income economies. If it now follows the headline rate on a downward path, the difference could be easily attributed to the implementation of Brexit and the idiosyncrasies of British energy pricing.
In that case, there would be nothing surprising in a smaller economy than the eurozone or the US suffering a bit more from a common shock, and its inflation path being a bit harder to predict. Core inflation, however, is not yet trending down.
Given the substantial cumulative increase in interest rates by the Bank of England, comparable to those of the European Central Bank and Federal Reserve, most forecasters believe that is coming. With many mortgages now resetting with higher interest rates, that transmission of monetary tightening is slowing the economy.
As restrictive policy takes hold, continued weak British growth, if not a recession, through the end of 2024 is expected to drive overall consumer price inflation down further towards the 2% target. Perhaps there will even be an unexpected positive outcome, similar to the near-immaculate disinflation under way in the US – meaning wage demands and price rises subside without a large rise in unemployment.
Implicit in these relatively sanguine inflation forecasts is the assumption that British inflation dynamics are largely the same as those in other high-income economies. On the left is the argument that what really drove inflation over the last 18 months was the energy and supply shocks from Russia’s barbaric invasion of Ukraine, and spillover from US inflation pressures; when those subside globally, as they now seem to be, inflation comes down in the UK.
On the right is the argument that all that matters for inflation is the credibility of the central bank’s commitment to price stability; once the Bank showed that it was tightening monetary policy, and that it would raise rates as high as necessary to slow price rises, inflation would also come down in the UK. Either way, we are done with this inflation cycle – that will soon become evident.
But perhaps not. Both of these models ignore potentially important aspects of the contemporary British economy that I fear will make inflation more persistent in the UK, and subject to more risk of re-acceleration than in the US or across the Channel. Some of these aspects of institutional political economy proved important to British economic developments in the 1970s and 1980s, and their recurrence in today’s economic environment bodes poorly.
Firstly, what wage growth there has been in the UK over the period of inflation since early 2022 has been concentrated at the upper end of the income distribution. In contrast, in the US, the lower-income workers have gained the most.
With the shortfalls of pay growth concentrated in the public health, safety and transport sectors, this is not sustainable. If the UK government continues to ignore the recommendations for modest pay catch-up in these sectors, either industrial action or further dysfunction of critical services is likely.
Either way, that would cause an increase in inflation. Of course, so would a meaningful rise in pay for relevant public sector workers, but done carefully and in a limited way, a deal would reduce uncertainty and the risk of future price and wage pressures.
Secondly, the direct price effects of implementing Brexit, particularly in the food sector and in administrative costs for small businesses and companies engaged in trade, are undeniable. That implementation process, though, is not yet complete. Even if this government continues to move towards more pragmatic relations with the EU, divergences in standards and regulation will increase costs and decrease availability of various imports, as will the end of various temporary exemptions. The base run rate of inflation will remain higher for some time as a result.
Thirdly, the UK is on its fourth government since Theresa May took office. Fiscal policy has been erratic as a result, even leaving aside Trussonomics as aberrant. Labour is committed to some version of budgetary rectitude if it takes office at the next election. Yet until somebody commits to a path of higher tax and investment, a decline in fiscal sustainability and productivity growth will be the result. That means a lower rate of nominal GDP growth with a given inflation target, which will induce recurrent paroxysms of spending and tax cuts, which will be inflationary.
In short, the UK has distinct persistent problems in the real economy that the US and euro area do not share. I believe that will show up as higher, more volatile inflation in the coming years, despite the Bank’s comparable monetary tightening and the slowdown in the economy it will induce. The more favourable global energy and supply environment will help, but it will not be sufficient for restoring price stability so long as these issues are unaddressed.
Adam Posen is president of the Peterson Institute for International Economics in Washington DC