Conflict in Ukraine is set to push UK inflation higher

Latest data shows that CPI inflation (which covers the average price of a typical basket of goods and services purchased by the UK consumer) rose to 6.2% in February. This was the highest rate of inflation since 1992, and marked a substantial rise from the 0.4% rate just a year earlier.

In broad terms, numerous factors had come together to drive prices higher (we have explored these in more detail in an earlier note):

• Rising global commodity prices: particularly crude oil prices, which have been steadily increasing since June 2020
• In particular, recent pressure on global energy prices led Ofgem to raise their energy price cap substantially in October 2021, with another hefty increase announced for April.
• Global supply chain disruption leading to a knock-on impact for prices of some goods, such as second-hand cars
• A surge in demand upon COVID-19 restrictions being lifted
• In particular, the composition of spending during the pandemic shifted significantly, with consumers spending more on goods and less on services. This is adding further to price pressures, with demand pressure on goods being met with supply constraints in goods production.
• Base effects: a number of exceptional factors (like the Eat Out to Help Out and the VAT cut for the hospitality sector) pushed inflation lower over 2020 and early 2021, which have now started to unwind

Following Ofgem’s announcement (on 3^rd February) about the upcoming price cap increase, and taking into account movements in global oil prices up until that point, we previously expected inflation to peak at around 7% in April.

It was expected to fall gradually thereafter, as the upward pressures outlined above unwound. However, inflation was nonetheless expected to remain high, only falling below the Bank of England’s 2% target in Spring 2023.

Russia is a key exporter of crude oil, refined petroleum products and gas. The implications for security of energy supply are far greater for Europe, where Russia accounts for 27% of EU oil imports and around 30-40% of gas imports. By contrast, the UK derives only a small share of its gas supply (less than 4%) and oil imports (around 8%) from Russia. However, exposure in some other areas may be greater: for example, Russian oil accounts for 18% diesel demand in the UK. The Netherlands is also a significant source of oil imports for the UK, much of which in turn comes from Russia.

Furthermore, given that the UK is a net importer of both oil and gas, it is heavily exposed to the global rise in the prices of both commodities:

• The price of Brent crude oil stood at $112 per barrel at the end of March – down from its peak earlier in the month ($129pb), but nonetheless up 12% on a month earlier (when Russia moved into Ukraine) and 32% higher since the start of the year
• Similarly, gas prices also remain historically high – up by 40% since the start of the year

The most recent rise in oil prices alone would push our forecast for the April peak in inflation to around 8% – marking its highest level since 1991. However, the actual peak could very well be higher than this, given the spike upward in other non-energy commodity prices for which Russia and/or Ukraine are prominent suppliers:

• There have been notable rises in the price of barley (up 36% since the start of the year), wheat (up 32%) and corn (up 23%)
• But aside from this, further upward pressure on food prices is also likely. Feedback from our members points to strong increases in the price of fertiliser (and one of its key components, ammonia), which will impact on crop yields further ahead. This is in addition to constrained supply of Ukrainian crops due to be harvested this summer (particularly wheat), hit by conflict on the ground
• Prices for a range of industrial metals have also spiked, such as nickel (up 54% since the start of the year), aluminium (up 22%) and palladium (used in catalytic converters – up 16%)

The most immediate impact of these price rises will be felt by businesses, through higher prices for energy and fuels, key raw materials and inputs into production (exacerbated by any further supply chain disruption arising from the Ukraine conflict). This is coming at a time when cost pressures on firms are already significant, with input price inflation at double-digits since mid-2021.

Our business surveys flag that cost pressures are being passed on further down the supply chain. If this is also the case with Ukraine-driven rises in key inputs, consumer prices will only rise further. However, households will be protected from some of the immediate impact on  prices, principally via Ofgem’s energy price cap (which will regulate the effect of higher energy prices to households’ utility bills).

Nonetheless, higher global gas prices are likely to push further increases in the energy price cap beyond April (something that we had not factored into our latest economic forecast), which would result in higher inflation for longer. The scale of this is uncertain at this stage, given the volatility in global energy prices. But at its worst, we could see another peak in CPI inflation in October (when the price cap is likely to rise again), rivalling the 8% expected in April.

It’s clear that we’re headed for a period of high inflation further ahead.

The economic impact will be felt most acutely via a squeeze in households’ incomes. The lowest income households will be hit hardest, given that a greater proportion of their income is spent on items most exposed to global price pressures – such as food and utility bills. In addition, these households have not been able to build savings buffers to the same degree as wealthier ones, leaving them further exposed to adverse economic conditions. The net impact will be a moderate, but still significant, impact on economic growth.

Slower growth and higher inflation leaves central banks in a tricky bind. In the UK, the Bank of England will have to balance the need to raise interest rates to keep inflation in check – particularly to stop it becoming embedded in price and wage setting – with the real wage squeeze weighing on economic growth.

At present, it looks like most of the Monetary Policy Committee (MPC) are leaning towards further rate rises, but flagged increasing concern over the outlook for economic growth. But should the cost of living crisis deepen further, it’s possible that the taps will need to be turned the other way.