Surging Inflation in the UK

Question 1: Which of the following factors is the primary reason for the rise in inflation in 2021?

Question 2: Will the inflation surge of 2021 prove persistent?

Summary

The CfM panel of experts on the UK economy is nearly unanimous that the current surge in UK inflation has been caused by supply side factors. These are mainly global in nature (commodity prices, supply chain disruptions), although Brexit may have exacerbated the problem. The global nature of inflation puts it mostly outside of the government’s control. The majority of the panel doesn’t believe that inflation will persist beyond 2022.

Background

The January 2022 CfM survey asked the members of its UK panel about the sources of currently surging inflation in the UK and whether they expect inflation to persist.

Surging UK, and global, inflation

Consumer prices in the UK rose by 5.4% (year-on-year) in December 2021, the highest annual rate of inflation recorded since the UK adopted an inflation target in 1992. This appears to be part of a global phenomenon, with US inflation at 7% and Eurozone inflation at 5%. These all are above the respective (official or unofficial) inflation targets of these areas. (Japan is an exception with a year-on-year inflation rate of 0.8% in December 2021).

What has caused this sudden rise in inflation? The most prosaic explanation is that this is merely due to base effects. Inflation was below target (0.8%) in 2020 and inflation in 2021 mostly compensated for this low rate of inflation. This is evinced by an annualized inflation rate of 3% over the past two years—roughly on target.

There have been, however, other factors that go beyond a statistical blip. Commodity prices have also risen dramatically this year and these have passed through to rises in UK energy pricesRising shipping costs have also passed through to consumer prices. Supply chains have been strained, most notably in semiconductor shipments. Pandemic-driven demand for electronics have been hitting limited supply due to Covid-19 labour market disruptions. Semiconductors are key inputs to goods ranging from automobiles to toys and have therefore translated to broader price increases. Leibovici and Dunn (2021) show that price increases in 2021 were far larger in industries with greater semiconductor dependence.

Supply chain disruptions were seen elsewhere, including a shortage of lorry drivers and abattoir workers in the UK (but also in other countries). Some have pointed to Bexit as a cause for labour shortages in these industries. Brexit has also increased costs for UK manufacturers due to the separate regulatory regimes in the UK and EU and disruptions to EU-facing supply chains.

These explanations are various variants on “supply side” pressures that have led to higher prices. Others have emphasized demand side forces including monetary and fiscal policy.

Larry Summers estimated in his Washington Post column of February last year that US fiscal measures were three times larger than the output gap, risking inflation. He warns that the US Federal Reserve’s complacency on price increases may have added fuel to the fire. Other prominent voices warning that fiscal policy may have led to inflationary pressures include former chair of the Council of Economic Advisors, Jason Furman, and former IMF chief economist, Olivier Blanchard. Both, however, point to other inflationary pressures as well. Summers and Paul Krugman debated this question in February, with the latter positing that inflationary concerns were overstated. When they revisited this discussion in a recent forum, Krugman acknowledged being excessively sanguine on inflation, but defended his earlier view that fiscal policy wasn’t the primary cause.

Some drivers of inflation, such as supply-chain disruptions, are likely to dissipate as Covid-19 moves from pandemic to endemic. However, short-lived inflation could become endemic itself if it leads to higher inflation expectations. These expectations may become self-fulfilling and lead to persistent inflation. Gerard Lyons warns in the Guardian that the Bank of England may be responding too late to the inflation surge, and it risks becoming persistent. There are some indications of rising inflation expectations. UK inflation protected gilts imply that the market expects inflation to exceed the Bank of England’s in the upcoming decade. (The gilts are indexed to RPI, which tends to rise 1 percentage point faster than the CPI, but implied RPI expectations are above 3% for more than 10 years.) While the implied increase is moderate, always below 4%, Reis (2021) warns that looking at average inflation expectations may understate inflation risks. A look at the full distribution of (US) inflation expectations in household and corporate surveys shows a substantial share of respondents expecting far higher inflation. Caballero and Simsek (2021) analyse how a central bank should respond to temporary supply contractions in a dynamic New Keynesian model with demand inertia and conclude that policy should frontload interest rate hikes to prevent entrenched inflation.

A debate has emerged in this context on how persistent inflation will be in upcoming years. This month’s survey asks the CfM panel of experts on the UK economy to evaluate the causes of currently high inflation and whether they expect it to persist.

The first question asks for the primary reason for rising UK inflation in 2021. The options were consolidated under several major categories, but panellists were asked to comment on the causes more specifically.

Question 1: Which of the following factors is the primary reason for the rise in inflation in 2021?

Twenty-one panel members answered this question. 77% of the panel thinks supply constraints were the main culprit for rising inflation rates, with individual dissenters choosing “base effects” or “fiscal and monetary policies” as the main causes.

Alessandra Bonfiglioli (Queen Mary University of London) summarizes the consensus view: “The supply-chain crisis affecting most rich countries, as well as the surge in energy prices in the whole of Europe, has certainly played a prominent role. In the case of the UK this was aggravated by the increase in import costs and the shortages of workers from the EU, many of which had returned to their home countries during the lockdowns and were unable/unwilling to come back due to visa issues.” James Smith (Resolution Foundation) concurs that “The biggest driver of inflation at the moment are conditions in global goods markets. In turn, the key driver there has been the normalisation in commodity prices. Issues in global supply chains have exacerbated this.”

The global and supply-side causes for UK inflation left the panel relative sanguine about longer run inflation and the accommodative policy stance.  David Cobham (Heriott Watt University) notes that “inflation expectations [are] not seriously unanchored (so far) and fiscal-monetary policies time-limited.” In a similar spirit, Simon Wren-Lewis (Oxford University) thinks that “we can eliminate excess demand as a cause… As UK output remains well below its pre-pandemic trend… There is no sign of higher persistent wage inflation, so equally this has nothing to do with generalised pressure from the labour market (and higher expectations).” Richard Portes (London Business School and CEPR) adds that “price increases [are] very heterogeneous across product categories,” which indicates that this has more to do with specific shocks than policy, and that “wage rises [are] also very heterogeneous.” Portes concludes that this puts him still on “team transitory,” economists who believe that current inflation will soon pass.

This brings us to the second question, where panellists were asked whether they believed that inflation will be persistent. To minimize ambiguity, we defined “persistent” inflation for the sake of this question, if it is still above 4% for the year of 2023 (December 2023 relative to December 2022). Of course, panellists answers may have been contingent on how the Bank of England will respond and their predictions are meant to reflect a joint prediction of the underlying price pressures and the Bank’s response to them.

Question 2: Will the inflation surge of 2021 prove persistent?

Twenty-one panel members responded to this question. A solid majority of 57% thinks the inflation surge will subside by 2023, compared to only 19% expecting longer-lived inflation.

Explaining why inflation will be transitory, panellists predicted that the supply side pressures would ease by 2023. Wendy Carlin (University College London) summarizes that “on the supply side some of the global factors exacerbating inflationary pressure will likely ease.” She also points to weak demand forces going forward that would bring back the deflationary concerns of the pre-Covid economy: “On the aggregate demand side, deflationary forces from the fiscal and monetary sides combined with the squeeze on living standards dampening consumption of lower- and middle-income households will act to reduce inflation.”

Others reminded readers that inflation is largely a policy choice of the Bank of England. Francesca Monti (Université catholique de Louvain) is uncertain whether inflation will be persistent and writes: “I don't think that this inflation is "transitory" in the sense that it will die out by itself without policy action. It is not persistent either, because monetary policymakers however have the tools to bring inflation down, but at the cost of a potentially very painful slowdown for the economy.” Panellist had differing predictions on whether the Bank of England would respond sufficiently to keep inflation low in upcoming years. Wouter den Haan (London School of Economics) concurs but expects and hopes that “the BoE realises that long-term credibility is at risk if they do not take action to fight persistent inflation and that the cost of losing this credibility is costlier than any short-term advantages of loose monetary policy.”  Michael Wickens (Cardiff Business School and University of York) is less sanguine. He believes inflation will be persistent because it will be accommodated by monetary policy. Instead, he believes that “Monetary policy should instead just accommodate the first-round effects.”

References and Further Readings

Caballero, Ricardo J. and Simsek, Alp (2021). “A Note on Temporary Supply Shocks with Aggregate Demand Inertia,” working paper.

Fernando Leibovici and Jason Dunn, (2021) “Supply Chain Bottlenecks and Inflation: The Role of Semiconductors,” Economic Synopses, No. 28. https://doi.org/10.20955/es.2021.28

Reis, Ricardo, (2021). “Losing the Inflation Anchor,” Brookings Papers on Economic Activity, Fall 2021.

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How the experts responded

Question 1

Participant Answer Confidence level Comment
Paul De Grauwe's picture Paul De Grauwe London School of Economics Supply constraints Confident
Martin Ellison's picture Martin Ellison University of Oxford Supply constraints Very confident
The supply side of the UK economy has been compromised during the Covid-19 pandemic. It has been a large shock, and relative prices need to change for the market mechanism to redirect resources to where they are most productive. Since it is easier to raise prices than lower them, prices overall will rise and inflation will result. Although I believe that supply constraints were the primary reason for high inflation in 2021, it was pleasing to see that supply was more resilient than I feared it might be when the pandemic began.
Sir Charles Bean's picture Sir Charles Bean London School of Economics Supply constraints Confident
Wendy Carlin's picture Wendy Carlin University College London No opinion or other Confident
For the UK, base effects, energy price rises, and the pandemic-induced distortion in consumer demand from services toward durable goods (interacting with a similar global pattern plus supply chain disruption) account for the rise in inflation in 2021. So, a cocktail of supply-side factors was responsible (rather than excess aggregate demand or inflation expectations).
Richard Portes's picture Richard Portes London Business School and CEPR Supply constraints Extremely confident
UK similar to US despite different policies. US fiscal impulse turned negative from 2020Q3 onwards. Price increases very heterogeneous across product categories. Wage rises also very heterogeneous. I’m still on ‘team transitory’.
David Cobham's picture David Cobham Heriot Watt University Supply constraints Confident
The combination of international Covid-related and UK Brexit factors surely dominates, with inflation expectations not seriously unanchored (so far) and fiscal-monetary policies time-limited.
Simon Wren-Lewis's picture Simon Wren-Lewis University of Oxford Supply constraints Confident
As UK output remains well below its pre-pandemic trend, we can eliminate excess demand as a cause. There is no sign of higher persistent wage inflation, so equally this has nothing to do with generalised pressure from the labour market (and higher expectations). We do know that both the pandemic and Brexit has caused supply problems.
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme Supply constraints Very confident
It may be a bit more complex as supply is struggling to meet demand which has shifted towards goods - some sectors still have excess supply.
Francesca Monti's picture Francesca Monti Kings College London Supply constraints Not confident
While stimulative fiscal policy and loose monetary policy (at least in historical terms) are certainly playing a role in driving demand and consequently inflation, supply-side constraints are more relevant, for post-Brexit UK in particular.
James Smith's picture James Smith Head of Macroeconomic Policy, Resolution Foundation No opinion or other Confident
The biggest driver of inflation at the moment are conditions in global goods markets. In turn, the key driver there has been the normalisation in commodity prices. Issues in global supply chains have exacerbated this (see recent helpful work from the FRBNY).
Costas Milas's picture Costas Milas University of Liverpool Supply constraints Confident
John VanReenen's picture John VanReenen London School of Economics Supply constraints Confident
Dawn Holland's picture Dawn Holland Supply constraints Very confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Base effects Confident
Wouter Den Haan's picture Wouter Den Haan London School of Economics Fiscal and monetary policies and non-policy demand factors Very confident
Alessandra Bonfiglioli's picture Alessandra Bonf... Queen Mary University of London Supply constraints Confident
The supply-chain crisis affecting most rich countries, as well as the surge in energy prices in the whole of Europe, has certainly played a prominent role. In the case of the UK this was aggravated by the increase in import costs and the shortages of workers from the EU, many of which had returned to their home countries during the lockdowns and were unable/unwilling to come back due to visa issues. However, fiscal policy also played a role by sustaining an otherwise plummeting demand throughout the pandemic.
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Supply constraints Very confident
Clearly there have been price rises due to supply effects. (The main point of zero emissions policy is to deter carbon energy use by reducing its supply resulting in it being more expensive.) But whether such price rises on their own should be referred to as inflation is debatable. I would describe inflation as the persistence of price rises due to second and third round effects such as wage increases in an attempt to maintain real incomes and subsequent price rises due to higher labour costs. In theory shocks to the economy such as supply shocks will result in different relative prices (including real wages) in the new equilibrium but not inflation (a persistent rise in prices) unless accommodated by monetary policy. There may be short-lived dynamics of adjustment to the new equilibrium which could be interpreted as temporary inflation. The policy issue is to allow these price changes but to avoid them being persistent.
Lucio Sarno's picture Lucio Sarno Cambridge University Supply constraints Confident
Linda Yueh's picture Linda Yueh London Business School No opinion or other Confident
Multiple factors
Natalie Chen's picture Natalie Chen University of Warwick Supply constraints Confident
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Supply constraints Confident
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics Supply constraints Very confident
Fiscal policy was largely in the form of transfers that didn't fully replace the demand that was lost due to Covid-19. The supply-side constraints are real and in some cases dramatic. I wouldn't attribute inflation to monetary policy although I do question the need to have kept monetary policy so loose for so long. There was a dire need for liquidity provision in the first half of 2020. Beyond this, I don't understand how low interest rates were to address any of the economic challenges posed by Covid 19. They may have mainly inflated stock and housing prices.

Question 2

Participant Answer Confidence level Comment
Paul De Grauwe's picture Paul De Grauwe London School of Economics No Confident
Martin Ellison's picture Martin Ellison University of Oxford Uncertain or no opinion Confident
The inflationary pressures from Covid-19 supply constraints should have largely eased by 2023. That leaves the future of inflation in the hands of monetary and fiscal policy, and the ability of policymakers to make the right judgements. Getting back to 4% inflation in 2023 is a tough call – it’s right at the level predicted by the inflation forward curve on UK gilts. I don’t think even the most optimistic policymaker would bet the house on inflation falling below 4% by 2023.
Sir Charles Bean's picture Sir Charles Bean London School of Economics No Not confident at all
Wendy Carlin's picture Wendy Carlin University College London No Not confident
On the aggregate demand side, deflationary forces from the fiscal and monetary sides combined with the squeaze on living standards dampening consumption of lower and middle income households will act to reduce inflation; on the supply side some of the global factors exacerbating inflationary pressure will likely ease. The damage to potential output is still unclear, however. Meanwhile, there is little sign of systematic wage increases building in lagged inflation. So, on balance, inflation may ease back somewhat in 2023.
Richard Portes's picture Richard Portes London Business School and CEPR No Very confident
Supply constraints will loosen, some prices will fall, real incomes will fall, consumer demand will weaken.
David Cobham's picture David Cobham Heriot Watt University No Confident
4% for the end of 2023 is a lowish bar for persistence, but even so it seems unlikely that it will be attained, partly because the underlying forces are both largely temporary and not so strong, and partly because the Bank is likely to respond by at least enough to keep expectations anchored.
Simon Wren-Lewis's picture Simon Wren-Lewis University of Oxford No Not confident
Forecasting inflation is a mug's game, because it depends on so many factors. What is clear is that the UK has not undertaken a large fiscal stimulus like the US, which means there will be no excess inflation caused by demand pressure. As the US experience suggests the pandemic did little to influence potential, which means any inflation will be temporary and should be ignored by the Bank.
Kate Barker's picture Kate Barker British Coal Staff Superannuation Scheme and University Superannuation Scheme No Confident
Francesca Monti's picture Francesca Monti Kings College London Uncertain or no opinion Confident
I don't think that this inflation is "transitory" in the sense that it will die out by itself without policy action. It is not persistent either, because monetary policymakers however have the tools to bring inflation down, but at the cost of a potentially very painful slowdown for the economy.
James Smith's picture James Smith Head of Macroeconomic Policy, Resolution Foundation Yes Confident
The current goods market shock will ease significantly through the course of this year but it will take time to fully pass through, and then feed through to non-tradables. So although I expect (UK) inflation to ease fairly rapidly later this year, the impact of the shock will take some time to subside completely. The question beyond that is the extent to which domestic inflationary pressures become apparent. With the labour market tightening we should see some pressure coming through but the extent is uncertain.
Costas Milas's picture Costas Milas University of Liverpool No Confident
Inflation will not be persistent provided that the Bank of England responds. What many seem to ignore, however, is the possible impact of the conflict between Russia and Ukraine. Rising and perhaps persistent geopolitical risk is not a ‘friend’ of the (global) economy. Putin’s policies and, consequently, economic sanctions against Russia have the potential of harming the Russian economy. These policies can also create contagion effects for the rest of the world which might delay interest rate rises.... How likely is this? A reasonable way of answering this very question is to look at the exposure of international banks to Russian private and public debt. Data from the Bank for International Settlements provide some very useful information. The exposure of selected banks around the world to Russian private and public debt is fairly low. For instance, the exposure of British banks and US banks is very low at 0.06 per cent and 0.37 per cent, respectively. Notice, however, that the exposure of Austrian banks to Russian debt currently stands at 3.6 per cent (of their total exposure worldwide) and that Italian banks have a 2.7 per cent exposure to Russian debt (results for Italy are not available after 2018Q3). All of the above seems to suggest that we should not worry too much about possible contagion effects through the banking channel. That said, the exposure of Austrian and Italian banks is arguably of some concern and therefore, if Russia invades Ukraine and economic sanctions are imposed, there is a slight(?) risk that economic pain will also be felt in Europe. Do not underestimate this very risk and its impact on monetary policy in the UK (and elsewhere)!
John VanReenen's picture John VanReenen London School of Economics No Not confident
Dawn Holland's picture Dawn Holland No Confident
Gino A. Gancia's picture Gino A. Gancia Queen Mary University of London Yes Not confident
Wouter Den Haan's picture Wouter Den Haan London School of Economics No Not confident
I expect that the BoE realises that long-term credibility is at risk if they do not take action to fight persistent inflation and that the cost of losing this credibility is costlier than any short-term advantages of loose monetary policy. Hopefully, I'm not wrong.
Michael Wickens's picture Michael Wickens Cardiff Business School & University of York Yes Confident
Yes because they will continue to be accommodated by monetary policy. Monetary policy should instead just accommodate the first round effects.
Lucio Sarno's picture Lucio Sarno Cambridge University Uncertain or no opinion Not confident at all
Linda Yueh's picture Linda Yueh London Business School Uncertain or no opinion Not confident
Natalie Chen's picture Natalie Chen University of Warwick Yes Confident
Chryssi Giannitsarou's picture Chryssi Giannitsarou University of Cambridge, Faculty of Economics Uncertain or no opinion Not confident
Ethan Ilzetzki's picture Ethan Ilzetzki London School of Economics No Not confident
Barring new lethal waves of Covid 19 or other disasters, supply constraints should relax before the end of 2022. The Bank of England and now the Federal Reserve have indicated intentions to reign in inflation and I take them at their word.