18 March 2021
Like watches for chocolate
Inflation is in the eye of the beholder – and rising.
by Frank O’Nomics
An old joke:
A man walks into a hardware shop and asks the price of a gardening fork.
“£20” comes the reply.
“But they only charge £15 down the road”.
“So why didn’t you buy one?”
“They’ve sold out”
“Ok. Mine are only £15 when I’ve sold out, so why don’t you come back then”.
What is your personal inflation rate? A question that should be carefully put at a time when exercise has been somewhat curtailed for most of us. In the context of the impact of price rises on our disposable income, however, the issue may not be seen as of any significance. When the opportunity to dispose of any income has been limited what do price increases matter? The danger is, we are becoming very relaxed about price inflation and may be in for a rude awakening.
The general public’s expectations for inflation are invariably high, but the low level of personal and business activity over the last 12 months has led people to revise these expectations to the lowest level for 4 years. To be fair the expectation for this year, of 2.7%, is still above the Bank of England’s target and the long-term expectation remains at a lofty 2.9%, but public perceptions of inflation tend to focus on key items of their spending, and it is those that seem most likely to be becoming more expensive.
The basket of goods used to calculate the level of CPI has just undergone its annual adjustment to reflect changes in buying patterns. The effects of the pandemic are clear to see – hand gel, jogging trousers and smart watches are now included, while canteen sandwiches and white chocolate have dropped out (the Milky Bars are now on someone else). Some of these changes could put modest upward pressure on the CPI, but the majority of people will care little. What they do care about is price rises in key elements of their expenditure – housing costs and energy prices. The already announced average rise in Council Tax (10% for London) and the bounce in oil prices (up 150% over the last 12 months) and an 8-9% rise in energy prices as the price cap has been removed, are all likely to prompt a revision to expectations. Current CPI is running at just 0.7% but index effects – from oil prices and lower VAT on some services from this time last year dropping out – will mean that CPI is likely to move towards, and potentially beyond, the Bank’s long-term target of 2% in very short order. Former MPC member Andrew Sentence has suggested 4-5% as possible later this year.
The big worry will be how the Bank of England will respond to the increase in inflation. The Governor of the Bank, Andrew Bailey, has said that there will be no tightening of monetary policy “until there is clear evidence that significant progress is being made to eliminate spare capacity and achieving the 2 per cent inflation target sustainably”. Clearly, the expected spike in inflation will not provoke a response – at least for a while. The problem is, that once the inflation genie is released, he will not like going back into his lamp. Price rises get factored in to expectations and wage negotiations. Further, having spent so long worrying about the potential inflationary impact of a weak currency, we have, in recent months been shielded from some of the rises in commodity prices by the strength of sterling. £/$ has rallied by almost 20% per cent and against the Euro by 10 per cent. The prospect of this being reversed at some stage could add impetus to inflationary pressures and cause a headache for the Monetary Policy Committee. When it came to looking at how to raise additional revenue to remedy the hole in government finances, many thought that an increase in VAT would be a rational move. From the point of view of generating cash once spending is unleashed post-lock down, this would have made a lot of sense. However, for those trying to keep the rise in prices within rational bounds it would have been a big risk.
One of the problems with CPI is that it gives a level of inflation that applies to a limited section of the population – I spend my money on a different mix of goods and service to you and hence our experience of inflation is likely to be very different. The pandemic has added an additional element to this disparity. Many will look at their expenditure over the last few months and be drawn into thinking that their disposable income going forward looks a lot healthier. It is true that the money saved over the last 12 months will give much additional short-term spending power. However, once spending patterns settle down, and people account for the increased cost of goods and services, they will discover that the reverse is true.
