UK: Why inflation shouldn’t be an issue for the Bank of England

The UK will release inflation and retail data this week, and unsurprisingly with the country stuck in lockdown, both are likely to be relatively depressed. Headline CPI will remain heavily constrained by energy prices, while more timely spending data points to a post-Christmas 4% fall in retail sales.

But with reflation becoming a key theme in financial markets, it’s a good time to ask, will the UK see price pressures re-emerge as the country reopens?

Strictly speaking, yes. Headline inflation is likely to be back to 2% by the end of 2021, though unsurprisingly a lot of that is down to energy. We’ll soon be no longer comparing current petrol prices to the severely depressed levels of last spring. A 9% increase in the household energy cap, and the end of the hospitality VAT cut, will also both add upward pressure.

But will it last? We think probably not, and that for a few key reasons, inflation is likely to drift back below target in 2022.

A lot depends on consumer spending, and there’s little doubt there is pent-up demand waiting to be unleashed once the economy reopens on a sustained basis.

The UK savings ratio has spiked to 17% as of the third quarter, well above pre-crisis levels. And we expect this to help drive a strong recovery in output through the spring/summer.

But there are caveats - the biggest being that this rise in involuntary savings has disproportionately benefited higher earners. A Bank of England survey from last year indicated many of those on lower incomes have seen savings fall, no doubt linked to the higher rates of redundancies and furlough among these workers.

This is important, because it tends to be lower-income consumers that drive the biggest changes in overall spending - a point demonstrated clearly in the US last year, where high-frequency data showed the rapid recovery in consumer spending was led by lower-income earners (buoyed by higher unemployment benefits and stimulus cheques).

In other words, the consumer story is likely to be strong - but it potentially has its limits.

Secondly, while the consumer rebound is likely to favour services over goods, the cost of these services tends to be fairly sticky.

In fact, despite the huge drop in demand for consumer services during the pandemic, core services inflation has actually been fairly stable. Once hospitality prices, which have been artificially depressed by a VAT cut, are removed, the rate of services inflation has stayed broadly in line with where it has been since 2018 (around 2%).

The same is likely to be true during the next stage of the recovery, though there will inevitably be exceptions. For instance, last year we saw haircut prices spike on reopening, though this was maybe down to PPE costs rather than higher demand. There’s also a case for accommodation to see a summer spike if foreign travel is banned.

Otherwise, many consumer-facing services, including restaurants/pubs, are often fairly price-competitive - and the chart below also shows that hospitality and leisure price categories have historically experienced less volatile inflation rates.

We can also draw some tentative conclusions from what’s happened to prices since the start of the pandemic. Consumers have spent more on goods than services last year for obvious reasons, and that appears to have helped push up the cost of things like vehicles, and household electronics. Durable goods inflation is running at 3.6% YoY, similar to the peak we saw after the post-Brexit collapse in the pound, only this time there was no real change in import prices.

There is also some evidence that retailers have been able to expand their margins. Prices of ‘core’ manufactured goods rose a little more quickly than producer output prices through last year.

But the impact on overall inflation of these demand-spikes has not been huge. Goods prices outside of some of those durable categories were typically stable or lower.