Forty-year high inflation: the UK braces itself for rocky times ahead

In April 2022, inflation reached 9% – the highest rate in 40 years. Driven by rising costs of energy, fuel, and food, soaring inflation is piling pressure onto low- and middle-income earners, who may now struggle to cover their monthly electricity bill.

And this is by no means the end of it: the Bank of England (BOE) expects the inflation rate to continue growing – up to 10% by the autumn – before gradually regressing to the baseline 2% target in around two years.

The last time inflation reached over 9% was 1982. This was a hangover from the economic chaos in the 1970’s – a decade plagued by rising oil prices and poorly executed monetary policies. At 9.1%, the inflation rate was, in fact, decreasing; in 1975 it checked in at almost 25% – the highest in peace-time history.

What is inflation?

Inflation is the tendency of prices of goods and services to rise over time, and the inflation rate represents how quick the rise is. Every month, the Office for National Statistics generates the Consumer Price Index (CPI) by calculating the cost of a sample of over 700 products and applying a weighting to each item depending on the relative spending on each per the results of the Family Expenditure Survey. It is compared it to the CPI in the same month a year earlier, and the percentage increase is the inflation rate.

The BOE aim for a 2% rate of inflation, which is in line with stable economic growth. A rapidly increasing rate represents unsustainable price increases, which markedly reduce the value of money. The failure of wages to keep up with inflation erodes away disposable income, resulting in less consumer spending.

Why has the inflation rate risen so much in 2022?

There are four factors driving rising inflation this year: global energy price increases, supply chain disruptions, reopening of the economy following COVID-19 restrictions, and the Russian invasion of Ukraine.

Global energy price increases

The prices of gas, petrol and coal have been creeping up since the easing of COVID-19 restrictions. During lockdown, road travel was limited to essential journeys only; the eagerness of travellers to make the most of newfound freedom has resulted in a rebound demand for fuel. Oil prices quickly jumped from a low of negative $40 per barrel at the peak of lockdown to $117 per barrel in March 2022.

Gas supplies were put under pressure by an unusually cold winter in 2020/2021, which resulted in higher demand to power central heating (further exacerbated by poor progress of governmental house insulation initiatives). This has been compounded by constraints on supply from Russia following Western Europe’s response to the invasion of Ukraine.

Supply chain disruptions

Shortages of key products naturally force up prices in a competitive market, as businesses and individuals are prepared to pay more to secure access to items in short supply. The most prominent example last year was the semiconductor shortage needed for production of computers, monitors, laptops, TVs, and refrigerators – the result of a surge in demand as people set up home offices and adapted to working remotely.

UK supply chains have been disrupted in recent years primarily by Brexit (causing labour shortages and border hold-ups following new customs declarations) and the effects of COVID-19 (virus outbreaks in factories and border restrictions limiting imports and exports). Labour shortages in combination with low unemployment rates have resulted in employee wage increases, which is generally one of the biggest expenses on the P&L for service-sector businesses.

Additional pressure has been applied by the re-emergence of COVID-19 in China (negatively affecting production),  logistical problems caused by freight ships stuck in the wrong places, and a shortage of container ships delivering products from China to Europe and the US. The results are deficiencies of staple products and higher transport costs – both of which push prices up.

To read more about UK labour shortages and supply chain challenges in recent years, please see our previous blog posts.

Reopening of the economy

Online sales generally performed well during enforced closure of non-essential retailers. As the economy reopened after easing of COVID-19 restrictions, the demand for products surged. House and car prices have all risen, fuel costs have gone up in part due to people travelling, and high street stores have seen footfall return. Businesses are not as reliant on heavy customer discounts to secure sales.

Unrest in Eastern Europe

Before the Russian invasion of Ukraine in February 2022, inflation was expected to reach 7% this year. The updated prediction from the BOE is 10%, driven by rising costs of energy and food. The Office for National Statistics attributes the higher than predicted inflation rates largely to the increase in the energy price cap in April 2022.

In 2019, Ukraine supplied 42% of the global exports of sunflower oil, and significant proportions of maize, barley, and wheat. The blockage of Ukrainian ports by Russian forces has limited exports, and the BBC report 20 million tonnes of grain are currently stuck in Ukraine. This is pushing up food costs across the world, while pushing down the value of these items in Ukraine, where they are currently in overabundance.

What measures are being taken to slow inflation?

Many of the driving forces of rising inflation cannot be influenced by governmental or BOE policies; global causes are beyond their control. Interest rates are one tool the BOE can use to try to curb spending and reduce economic growth.

Using interest rates to manipulate the economy is an example of monetary policy. The BOE increased interest rates from 0.75% to 1% on 5 May – the highest since February 2009 and the fourth rise in six months. The aim is to reduce consumer spending, thus resolving the supply demand mismatch and giving prices a chance to recover. A higher base rate discourages new debt due to higher interest payments and increased mortgage repayments, limiting disposable income available to consumers. This discourages spending, and instead promotes saving in interest-bearing accounts.

Other methods can be used to cut consumer spending, such as reducing disposable income through lower wages and higher income or VAT tax rates. Given the tightening labour market, employees are in short supply and have the power to negotiate higher wages, leaving this option unfeasible. The International Monetary Fund have encouraged Rishi Sunak to bring forward tax rate increases for wealthier earners (sparing low earners) to reduce the risk of an extended period of high inflation.

What impact does inflation and higher interest rates have on business and the economy?

Inflation is the result of rapid economic growth – aggregate demand exceeds supply, and prices increase as key items are in relatively short supply. Costs are pushed upwards, putting pressure on the budgets of individuals and businesses alike.

Business expenses are going to continue increasing, and those holding variable debt (loans, overdrafts, and credit cards) are going to see higher interest payments in relation to these. HMRC’s late tax payment interest will also go up (in line with the base rate) making it more expensive for those paying their taxes late. Profit is likely to be further squeezed by a drop in turnover, caused by customers experiencing their own financial strains.

Facing a future filled with uncertainty

It’s tricky to predict how high inflation will go. Though the BOE have settled on 10%, the impact of unexpected global events has been adeptly illustrated by the tragic events in Eastern Europe.

Interest rates take time to have a tangible effect on inflation, and it’s likely to be several years before we see inflation settle back down to the BOE’s desired 2%. Interest rates are anticipated to continue rising, reaching an estimated peak of 2.5% mid-2023.

Another Ofgem review of the energy price cap is schedule for October 2022, and already we’re hearing predictions of significant increases – Jonathan Brearly (Ofgem CEO) reports an expected increase of £800 to £2,800 per year, pushing more UK households into fuel poverty.

The National Institute of Economic and Social Research forecast negative economic growth for the second half of 2022, meeting the formal definition of a recession. On 16 May, Rishi Sunak announced a £15 billion package to help with the current cost of living crisis, which the Prime Minister believes could deflect the impending economic contraction. Only time will tell, but it seems entirely possible the UK is heading for a tough time in the years ahead.

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