Living with Inflation in the UK

Steep inflation in the U.K. driven by food and energy prices

Data published by the Office for National Statistics on the 16th of November showed that inflation rate in the UK hit a 41-year high, with consumer prices rising to 11.1%. For those of us living in the UK, gone are the days of a £3 Tesco meal deal - it is now £3.40, equivalent to a 13% increase in price.

Indeed, the concept of inflation is no stranger to us. Inflation is essentially the rise in the prices of goods, or in other words, the loss of purchasing power of money. The Consumer Price Index (CPI) is the most commonly cited indicator of inflation. The CPI calculates the change in cost to purchase a fixed basket of goods. The inflation figure indicated by the CPI is also known as headline inflation. Headline inflation includes elements of the economy that display seasonality or extreme volatility, such as energy and food. Core inflation on the other hand excludes volatile components of the economy. The prices of these volatile components are subjected to forces other than the traditional supply and demand. For instance, food prices are affected by extreme weather conditions while energy prices are affected by geopolitical tensions.

It is important to note that in the UK, while headline inflation saw a leap to 11.1%, core inflation remained at 6.5%. This means that the inflationary pressures are felt more acutely by lower-income households as energy and food constitutes a larger part of their expenses.

But how did we end up in this steep and prolonged inflationary environment? The following paragraphs will discuss two main ideas:

• Pent-up demand as a result of COVID lockdowns driving up prices

• Energy crunch driven by high gas prices and insufficient infrastructure investment

Reopening post COVID led to increase in demand for goods and services and a tight labour market

The Bank of England and other central banks worldwide have an inflation target of 2%. The inflation target is set to ensure price stability and economic growth. The government and central banks try to keep inflation at 2% by controlling the supply of money available to banks, businesses and consumers. When the pandemic hit, there was an injection of fiscal stimulus to boost the economy. Moreover, households also increased their savings during lockdowns. As a result, when the economy reopened, there was pent up demand for goods and services. Spending across sectors increased, driving up prices.

Against this backdrop of higher consumer demand, the labour market in the U.K. is facing a general shortage of available labour post COVID. As illustrated in the chart below published by the Office for National Statistics on the 5th of September, unemployment level started falling while the number of vacancies increased in the time between 2020 Q1 and 2022 Q2.

This situation where there are more vacancies than available workers is known as a tight labour market. The main concern here is the possibility of a wage-price spiral, which happens when employees demand for higher pay in order to cope with inflation, which leads to increase spending and thereby reinforcing inflationary pressures on prices. However, the risk of a wage-price spiral seems to be contained currently in the U.K., as real wages (i.e. value of wages adjusted to inflation) is falling, demonstrating weaker consumer purchasing power.

Conclusion? We are not seeing our wages increase in line with inflation. However, maybe we can find consolation in the knowing that the risk of a wage-price spiral is averted while we munch on on a Tesco meal deal sandwich rather than a bougee bagel from your artisan bakery.

Russia-Ukraine war and lack of investment led to increased gas and energy prices in the UK

Gas is the UK's largest energy source, supplying 43% of the total UK energy in 2021. While the UK is not dependent on Russia for gas supply, it is exposed to global gas prices.

Half of the UK's gas supply comes from its own territory, the region of waters surrounding the UK, known as the UK Continental Shelf. The other half is imported from different countries, with Norway being the UK's primary gas supplier. However, a report by OEUK in March 2022 indicated that the UK is becoming more reliant on oil and gas imports as output from the North Sea showed a decline. This is due to political disagreements around issues like climate change and windfall taxes on gas products.

An increase in gas imports at a time when there is disruption in global gas supply has led to increased gas and energy prices in the UK. Hence, the problem of high gas and energy prices stems from a lack of investment in the gas sector and renewable energy infrastructure. However, the high cost of gas as a result of supply disruptions following the Russian invasion has exacerbated the problem in the UK.

Change in the energy sector might take awhile so til then, it looks like we will have to find ways to make our homes more heat efficient this winter!