We Shouldn't Be Worried About Inflation

5 reasons why

This morning the ONS released the latest inflation figures. It caused some alarm among commentators as it increased by more than expected and is now at 3.8 per cent which is considerably above the Bank of England’s target of two per per cent. The dedicated readers among you will remember that just the other week I voted for a rate cut on City AM’s Shadow MPC and I set out here why I felt the actual MPC had got it right. The MPC has come in for quite a bit of criticism today but I still think that they made the right decision in voting to lower Bank Rate.

First, obviously inflation being above target is problematic for the Bank. Moreover, the fact that it has been creeping up in recent months is less than ideal. However, this has not come as a surprise to the Bank or for most economists. This was forecast to happen and, although it has increased by more than expected, it is still below where the Bank has projected it to peak (four per cent by the end of the year). As such, it is not as though the MPC has been caught napping (which is a fair criticism of it from a few years ago).

Second, none of the warning signs that we’d expect to see if inflation was to spiral out of control again are flashing. Money supply growth is relatively stable which is a key driver when it comes to inflation. As I’ve written before, it is a factor which has not been given sufficient consideration by the MPC in the past and that is why inflation was allowed to get out of hand after the Pandemic. It is also why the Bank attempted to overcorrect by hiking rates too high and then not lowering them quickly enough. Money supply growth matters when it comes to inflation and it’s thankfully not acting in a way that should alarm us.

Third, services inflation is relatively high and would normally be of concern but if you strip out transport costs (especially air fares) and hotels then the picture is far rosier. I appreciate that this is akin to saying ‘If my grandmother had wheels then she would be a bike’, but it is worth noting. This is primarily a one-off, seasonal change and so we should not expect it to continuously drive up the cost of living for households. Moreover, when one considers food inflation (which is obviously a major concern for families), this has been driven by the UK experiencing a drought.This has negatively impacted crop yields and so prices have increased as a result. There is very little that the Bank can do about this.

Fourth, we are starting to see some of the consequences of the Budget. The hike to Employers’ NI and the increase to the minimum wage have increased costs for firms. These are now being passed onto consumers in the form of higher prices. Again, while this is of concern to the Bank, it’s not really one which can be solved through monetary policy.

Finally, the labour market is in a bad way. Taking an optimistic view we could say that this is likely to be disinflationary and so we should expect inflation to fall more quickly than the MPC has forecast. Regardless, as I wrote over the weekend things are starting to look very grim for workers and look set to get even worse which will have implications for economic growth. The labour market and the wider economy needs all the support it can get right now and so loosening monetary policy was the right thing to do.

As such, the Bank got it right in voting for a 25 basis points cut but not going any further. There is still a great deal of uncertainty around inflation but there does not seem to be any reason at this stage to be alarmed. I don’t yet know how I will vote at the next Shadow MPC meeting but at this stage it will likely be for a hold to Bank Rate.

Thanks as ever for reading. Ben.