Surging UK Prices Defy Efforts to Tame Inflation

Britain has an inflation problem that’s making decisions more difficult for Prime Minister Rishi Sunak and the Bank of England (BOE).

While inflationary pressures are subsiding across most of Europe and the United States, the UK last Wednesday posted a 10.1 percent increase in its headline consumer prices index. That marked the seventh month in double digits and the second significant upside surprise.

The figures indicate that the worst cost-of-living squeeze in more than a generation is continuing in the year before Sunak is likely to call the next election. And it ramped up bets for the BOE to boost interest rates—which were less than 1 percent for much of the past decade—to 5 percent by September, which will exacerbate the pain on consumers and perhaps boost unemployment.

The BOE is “in a really difficult position,” said Karen Ward, chief market strategist for Europe at JPMorgan Asset Management and an external adviser to UK Chancellor of Exchequer Jeremy Hunt. “It has to create job insecurity and demand insecurity. That’s how you stop people asking for more pay and stop companies putting up prices. That’s not nice.”

The latest reading may force a shift in tone from BOE Governor Andrew Bailey, who for weeks has said traders shouldn’t assume rates will spiral higher. That was interpreted as preparing the ground for a pause in the quickest tightening cycle since the 1980s.

Investors quickly priced in three more rate hikes this year, after last Wednesday’s inflation figures and last Tuesday’s jobs data, which showed wage growth remained uncomfortably strong.

Set against major peers, the UK’s sticky inflation looks even more stark. Over the same two months, inflation dropped from 9.2 percent to 7.8 percent in Germany; 7 percent to 6.6 percent in France; 8.5 percent to 6.9 percent in the Eurozone; and from 6 percent to 5 percent in the United States.

Sunak has made cutting inflation in half this year one of his top priorities, but after three months of data, consumer prices are back where they started. Inflation has now been above the BOE’s 2 percent target for 20 months. So far, Sunak’s government has been supportive of the Bank of England and careful not to attack the UK’s institutional framework, as his predecessor, Liz Truss, did with disastrous consequences.

But the BOE, which was accused of moving too slowly as inflation started to build in 2022, is in a particularly awkward position. It has already raised interest rates from 0.1 percent to 4.25 percent since December 2021, and Bailey and his colleagues say much of the impact of those hikes has yet to hit the economy.

The BOE, which softened its guidance earlier this year, would clearly like to stop—or pause—because policy is feeding into the real economy more slowly than usual, now that so many households are on fixed-rate mortgages. Instead, markets are now anticipating a further tightening for borrowing costs.

Britain, according to the BOE Chief Economist Huw Pill, has the worst features of the U.S. and Eurozone at the moment. It suffered the swinging energy price shock that hit Europe after Russia choked off natural gas exports to the region.

The UK has also seen the most workforce dropouts of all major advanced economies, and is the only one with fewer workers now than before the pandemic. The employment rate is lower than in 2019, with hundreds of thousands more people off for long-term sickness than before the pandemic. Post-Brexit visa rules also have added labor market frictions that did not previously exist, Ward added.

Food price inflation was the big shock in the March numbers, rising a record 19.1 percent, the most in more than four decades. That offset lower transport costs as fuel prices fell. What made the spike more surprising was that global food commodity prices, as measured by the FAO Food Price Index, have been declining for a year.

Part of that can be explained by the buying practices of big food producers in the UK, who take out long-term commodity contracts. That means price reductions don’t immediately feed through.

Food makers like Unilever Plc have been protecting their margins, too. That company’s CEO Alan Jope said in January that while inflation had peaked, pricing had not.

“Absolute pricing rarely falls very much,” said Martin Deboo, consumer goods analyst at Jefferies. “We expect consumers to be paying permanently more for products in 2023 onwards than they did in 2021. But we expect the benefits of lower inflation will be dealt back principally by much higher promotional intensities.”

Food prices contributed 1.8 percentage points to the March inflation number, but base effects will automatically reverse in June and knock 1 percentage point off headline inflation, Ward said.

To complicate matters further, the UK’s headline inflation rate is not directly comparable with other nations. About 3 percentage points of March’s 10.1 percent inflation rate was related to energy prices. Those have fallen sharply this year, but very little is captured in the UK, as household energy bills reset only every three months.

Ward estimated that plummeting energy prices accounted for 1.5 percentage points of the 1.6 percentage point drop in Eurozone inflation between January and March. In the UK, household energy prices were unchanged, resetting only at the start of this month.

All else equal, the new price cap will automatically lower UK inflation by 2 percentage points next month, Ward said. Using current energy prices, the September reset will bring inflation down by another 1 percentage point.

“The difference between the headline rates is due to energy,” said George Buckley, chief UK and Eurozone economist at Nomura. Britain, he said, “currently has the highest energy price inflation.”

When looking at core inflation, which strips out volatile food and energy prices, the UK is not such an outlier among European countries. By that measure, prices grew at a stable pace of 6.2 percent in March, while the Eurozone rate accelerated to 5.7 percent.

“The fact that they’re only a half percent adrift does not suggest to me that core is a big driver of the difference,” Buckley said.

All else equal, anticipated drops in food and energy prices should lower inflation from 10.1 percent to around 6 percent by September. For the BOE, which has to respond on May 11, it will come too late, and the stickiness of underlying prices will be too problematic to ignore.

 

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