Whether or not inflation proves in the end a poor adversary against central banks’ efforts to defeat it, it is certainly proving persistent as a topic of conversation.
Although there is growing consensus that price growth has peaked in advanced economies, and that many of the forces that drove inflation up last year have gone into reverse and are now exerting a downward pressure on headline rates, discussions and warnings about the year head have not ceased.
While some economists envisage sharp declines in inflation in almost all economies in 2023, and at a more dramatic rate than the central banks’ consensus, others warn against complacency and underline the danger that some elements of inflation could prove interminably difficult to squeeze out.
Should we expect inflation to fall hard and fast this year or to only budge slowly? It’s a key question given the destruction high inflation and the accompanying cures can cause, evidenced in both the cost of living crisis and mayhem in the tech sector. Terry Smith’s growth-focused Fundsmith equity fund didn’t escape the fallout from rising interest rates and the abrupt end to easy stimulus money, recording a fall over the year of 13.8 per cent, with the chief detractors in the fund’s performance last year being Meta, PayPal, a company Smith has now sold out of, Microsoft, Idexx and Amazon. He expects the bumpy ride to continue because “we have no idea when the current period of inflation and central bank interest rate rises… will end”.
Giant increases in energy prices last year were a major driver of inflation and thus recent reductions in gas and oil prices, driven by lower demand, will continue to deliver falls in the headline rate. They should certainly mean lower heating bills for UK households later this year. Taking a longer-term perspective, it’s worth noting that the energy crisis also sparked what the International Energy Agency has called an unprecedented momentum in the drive to switch to renewable energy sources. It calculates that the world is set to add as much renewable power in the next five years as it did over the whole of the past two decades. And although that’s not entirely astonishing given the impetus behind climate change goals, it’s still an increase of 30 per cent on the amount of growth that was expected at the end of 2021.
A reversal in food and commodities prices is another factor pushing inflation down, along with an easing of goods and services supply side constraints, while the cloud of recession is expected to curb consumer demand, another depressant. Shipping costs, producer prices and shortages indicators are all flashing green too. But a win isn’t in the bag yet and that’s largely because there are knotty areas that might mean some types of price growth become entrenched. That’s particularly the case in the UK where there are additional domestic factors at play compared with, say, Europe.
Huw Pill, chief economist at the Bank of England, notes that inflation in the UK could become a persistent problem through “second round effects”. These include higher gas prices (although gas prices have eased, they are still higher than they were a year ago) and ongoing labour market tightness, which includes the decline in participation rates among our working age population, particularly in the 50 to 65 age group. Strong wage growth, as employees try to protect their real income, and companies trying to maintain real profits as both groups struggle with the consequences of imported inflation, increase the risk that domestically generated inflation will “achieve its own self-sustaining momentum”, Pill warns.
Although pay awards are on average coming in lower than the rate of inflation, the likelihood is that pressure to restore real income levels to where they were prior to this bout of inflation will persist beyond this year, and may only ease if recession bites hard and job losses begin to mount. Economic slack and rising unemployment would weigh against domestic inflationary pressure, agrees Pill. But they may not be enough.
