Above-target inflation is here to stay as British economy strengthens

Andrew Sentance
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UK INFLATION has picked up again in May to 2.7 per cent on the consumer price index, after a surprise fall to 2.4 per cent in April. It has remained stubbornly above the Bank of England’s 2 per cent target since the financial crisis. With the exception of six months after VAT was cut in 2009, this continues a long run of above-target inflation, which began in late 2007 and has included two spikes over 5 per cent.

For once, high petrol prices are not to blame. Over the past year, petrol prices have fallen slightly, helping to hold down inflation. In other countries, an easing of global inflationary pressures has brought inflation down significantly. In the US and in the Eurozone, inflation is just half the UK rate – 1.4 per cent according to the latest figures.

There are two main reasons why our inflation rate has been stubbornly high. The first is the big fall in the pound since 2007, which has pushed up the cost of imports much more than in other countries. The second is the stubbornly high rate of services inflation, which has averaged nearly 4 per cent over the past decade – double the inflation target. Services account for about half the consumer basket. So it is very difficult to bring the inflation rate back down to 2 per cent while these prices are rising at double the target rate.

In the short term, inflation may rise higher as we move through the summer. If it rises above 3 per cent, the incoming Bank of England governor Mark Carney will have to write an early letter of explanation to the chancellor – not an auspicious start to his term of office.

Throughout this long period of above-target inflation, the Bank of England has promised a return to the inflation target over the years ahead. Though this remains the official forecast, it still looks too optimistic.

First, the UK economy is now picking up again after a period of disappointing growth over the past two years. As the economy strengthens, businesses may start to push through bigger price rises, and wage increases may also pick up from their current low rate.

Secondly, global economic growth is expected to recover next year, with the prospect of better economic news in Europe and a pick-up in some of the emerging market economies which have slowed recently. Since the early 2000s, stronger global growth has been accompanied by rising food, energy and commodity prices, as the supply of these vital resources has struggled to keep pace with demand. We may see another burst of this global energy and commodity price inflation – including higher oil prices – as the world economy picks up momentum again.

Thirdly, there is still the risk of a further fall in the pound adding to inflation – particularly while the official policy appears to be supporting a weaker currency to help rebalance the economy. So far, the Monetary Policy Committee has been reluctant to raise interest rates to counter this tide of sterling weakness and above-target inflation. But maybe the new governor will take a different view.

Andrew Sentance is senior economic adviser to PwC and a former member of the Bank of England’s Monetary Policy Committee.