UK inflation heading towards a 40-year high

In broad terms, numerous factors have come together to drive prices higher over the past year (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, higher global energy prices led Ofgem to raise their energy price cap substantially in October 2021, with another hefty increase implemented in April 2022.
• Global supply chain disruption has had 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 has added to price pressures, with strong demand for 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. These effects have now started to unwind, with the return to a 20% VAT rate in hospitality expected to show up in the April inflation data.

Russia’s invasion of Ukraine and the response of Western governments has added a further impetus to cost and price pressures, given disruption to the two countries’ exports of oil & gas, industrial metals and foodstuffs.

• The price of Brent crude oil stood at $110 per barrel on May 4th– down from its post-invasion peak in early March ($129pb), but nonetheless up almost 60% since May last year.
• UK gas prices have eased in recent weeks, but also remain historically high – around 160% higher than in May 2021.
• Prices for a range of industrial metals have also fallen back from post-invasion peaks but have nonetheless trended higher over the past year (for example, nickel prices are up 74% over the year, while aluminium prices are 20% higher).
• One of the most enduring effects of the Russia-Ukraine war so far has been on food There have been notable rises in the price of wheat (up 52% over the year to May), barley (up 49%) and corn (up 35%).
• Additional pressure on global food prices will come from the impact of the war on global fertiliser prices, which have risen by 50% since the invasion, given both Russia’s role as a major exporter of fertilisers and the chemical feedstock, as well as higher energy costs for fertiliser producers. With signs that farmers are already curbing their use of fertilisers, particularly in developing countries, this is expected to weigh on yields for a range of global crops, in addition to constrained supply of Ukrainian crops due to be harvested this summer (particularly wheat), hit by conflict on the ground.

Producer price data for March provided early evidence of the impact of these cost pressures coming through the supply chain. The rate of growth in UK producer input prices rose to 19.2% in the year to March (up from 15.0% in February). This was the highest recorded rate of input price inflation since data began in 1997, with the largest contributions coming from crude oil (+5.2pp), followed by metals and minerals (+4.7pp) and chemicals (+3.4pp).

Input cost pressures continued to feed through to output prices, which rose by 11.9% in the year to March (up from 10.2% in February), the highest pace of output price inflation since September 2008. The largest contributions to the rate of annual output price growth came from metals machinery & equipment (+2.9pp), followed by transport equipment (+2.8pp) and food products (+2.5pp). Moreover, these data do not include the output prices charged by firms in the services sector, which rose by 4% in the year to Q1, the fastest rate since records began in 1999.

Our business surveys point to further increases in costs and prices in the months ahead. For example, the latest Industrial Trends Survey (ITS) revealed that average costs in the quarter to April grew at the fastest rate since the quarter to July 1975, with a similar pace of growth expected in the next three months. The most important factor influencing expected cost growth was raw materials costs (80% of respondents said this extremely important), followed by energy costs (59%), transport costs (41%) and labour costs (38%). Meanwhile average domestic prices in the quarter to April rose at the sharpest pace since October 1979 and expected to accelerate further in the next three months, with the expectations balance the highest since January 1977.

All of this suggests enduring pressure on consumer prices in the months ahead. It’s likely that CPI inflation rose to around 9% in April, as the Ofgem energy price cap came into force. The rate of inflation may ease a bit over the summer months (thanks mostly to base effects), but it is unlikely to fall below 7% any time in 2022 and could swing back up again in October if the energy price cap is raised again. The scale of any such increase is uncertain, however, given the volatility in global energy prices, but at worst we could see another peak rivalling the one expected in April. Indeed, in its May Monetary Policy Report, the Bank of England predicted that inflation would peak at just over 10% in 2022 Q4, which would be the highest rate since 1982, before falling rapidly back towards its 2% target by Q2 2024.

Even this forecast is subject to a high degree of uncertainty. In particular, the pace of Europe’s transition away from Russian energy could have an important influence over global energy prices in the coming months. And so long as global supply chains remain stretched, they will remain sensitive to further shocks. Recent lockdowns in China have led to widespread disruption to industrial production and transportation. The impact of this on the UK and global cost pressures won’t be realised for some months.

The economic impact of high inflation 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 significant hit to economic growth, with the Bank of England assuming that GDP will contract in Q4 this year, in part because of the projected rise in household energy bills.

Slower growth and higher inflation leave central banks in a tricky bind. In the UK, the Bank of England is balancing the need to raise interest rates to keep inflation in check – particularly to stop it becoming embedded in price and wage setting – with the impact of the real wage squeeze on economic growth. Following its early May meeting, the Monetary Policy Committee (MPC) raised interest rates by a further 25 basis points, to 1%, and another two or three increases later this year looks likely. However, the MPC is also increasingly becoming concerned over the outlook for economic growth. Should the cost of living crisis deepen further, it’s possible that the taps will need to be turned the other way.