19 January 2023

Inflation is coming down – but it’s nothing to do with the Government


There was little to cheer in the latest UK inflation data and nothing at all of any value in the Chancellor’s response. Indeed, Jeremy Hunt’s ‘coffee cup explainer’ (which you can watch on social media here) was both naff and nonsensical.

There is at least some good news. The headline rate of inflation has peaked in the UK, just as it has in the US and the euro area. The CPI measure fell again in December, to 10.5%, from 10.7% in November and the high of 11.1% in October. This mainly reflects lower fuel price inflation, but inflation also fell for many other goods, including clothing and footwear and household items.

The bad news is, of course, that 10.5% is still far too high. Food price inflation continued to accelerate, from 16.4% to 16.8% on the CPI measure. ‘Core’ inflation (excluding food and energy) is proving sticky too, holding at 6.3%, as services price inflation rose from 6.3% to 6.8%.

The strength of core and services inflation will rattle the hawks at the Bank of England. They are worried that labour shortages could drive a ‘wage-price spiral’. Even if headline inflation plummets this year (as it surely will when the global energy and food shocks unwind), underlying inflation could remain well above the Bank’s 2% target.

Nonetheless, the ‘wage-price’ fears may be overdone. Wage growth is still running well below the prevailing rate of inflation, so there is little sign of an upward spiral. In the meantime, inflation expectations are already coming down and the labour market is starting to cool.

The monetary drivers of inflation have gone into reverse, too. In general, higher wages can only raise overall inflation if this is accommodated by monetary policy or, put another way, if there is enough new money in the economy to pay higher wages.

The reassuring point here is that the money supply is no longer expanding rapidly: the 12-month growth rate of the main measure M4ex was just 1.6% in November, down from more than 15% at the start of 2021.

In my view, there is still a good case for one final half-point hike in official interest rates, to 4%, in order to ram home the message that the Monetary Policy Committee (MPC) is serious about getting inflation back down again and to restore some credibility. But with monetary conditions already much tighter, and the full effect of last year’s rate increases yet to come through (especially in the mortgage market), the MPC may not have much more work to do.

This is perhaps just as well, because it is not obvious that the Government has a clue. For a start, the Chancellor’s explanation of why inflation is now so high did not even mention the monetary drivers. This is, alas, par for the course. The Bank of England prefers to pin all the blame on external factors too.

The Government’s promise to ‘halve inflation’ this year is not worth much either. Inflation will tumble anyway, even if the Chancellor does nothing. If inflation does only fall by a half (to around 5%) that would actually leave it higher than many independent forecasters are expecting.

Worst still, the Chancellor gave a pitiful answer to the question ‘how are we going to halve it?’. His plan had two parts. The first was more investment in renewables and energy efficiency. This will have next to no favourable impact on inflation in the short term, and could even add to it, depending on how the additional spending is financed. The real game-changer for inflation here is what happens to global energy prices, which have already fallen sharply.

The second bit of the plan was ‘balancing the nation’s books’. At face value this is a reference to the planned tightening of fiscal policy to get debt falling again as a share of national income, within five years. This has helped to stabilise the financial markets, thus lowering borrowing costs. But while this is clearly welcome, it will have little impact on inflation in the short term either.

I suspect this is really a nod to the argument that the Government cannot afford bigger pay rises for public sector workers because this would add to inflation. However, that also depends on how any pay rises are financed. And if that is what the Chancellor meant, then why not say so explicitly? Perhaps this is all too complicated for a two-minute video on social media. But then why bother?

At the end of the day, getting inflation down is the Bank of England’s job anyway. This is not to say that there is nothing the Government can do. Improvements to the tax and benefit system to make work pay would help to ease labour shortages. Lowering the burden of regulation in a wide range of areas, including the housing market and childcare, would reduce costs too. But progress here seems to have stalled.

In short, the worst of the inflation shock is now behind us, and the Bank of England should not have to raise rates much further. However, simply halving inflation and returning the economy to growth (any growth) is still a very low bar for success.

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Julian Jessop is an independent economist.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.