June 14, 2022

Chart of the Week: Why UK inflation could prove sticky

by Fathom Consulting.

UK inflation is soaring while growth is slowing:[1] the classic hallmarks of a negative supply shock. There are many sources of that shock: distortion of global supply chains during the pandemic, the deadening effect of Brexit on UK trade flows, and higher food and energy prices due to the conflict in Eastern Europe. The right thing for policymakers (monetary and fiscal) to do in the face of such a shock is to ‘see through it’: the shock will drive prices up and aggregate demand down, but there is no impact on inflation in the medium term, so there should be no response of macroeconomic policy, even if some redistribution towards the worst-affected people is necessary. But that logic only holds for as long as so-called ‘second-round effects’ are controlled. The supply shock makes us all worse off, an effect that cannot be avoided, but it can be aggravated if wages respond: higher wages will drive prices up even further. Over the last three quarters unemployment has fallen, but wage growth is accelerating (9.9% in the twelve months to March). This could be the start of second-round effects taking hold, or it could be the result of a contraction of labour supply in the UK thanks to Brexit. Either way, it means inflation is likely to be particularly sticky in the UK.

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[1] According to the Office for National Statistics, UK GDP contracted by 0.3% in April, after a decline of 0.1% in March.

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