High inflation will remain permanent fixture in UK economy, says EY ITEM Club report

20 May 2013

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Inflation will remain above Chancellor’s 2% target for foreseeable future
 
Persistently high inflation has knocked almost 3% off UK growth over the last three years and is set to remain above the Chancellor’s target for the foreseeable future, according to the EY ITEM Club.

In a special report released today, the EY ITEM Club says that had inflation averaged 2% over the last three years – rather than 3.5% - UK GDP would now be over £10bn higher.

And there’s little good news ahead. Inflationary pressures will peak over the summer, while a strengthening UK and global economy is unlikely to see inflation dip below 2.5% over the next 4 years.

Corrosive impact on UK growth

Carl Astorri, senior economic advisor to the EY ITEM Club, comments: “High inflation has had a corrosive impact on the UK economy over the last three years, eating into household spending power which has taken its toll on the high street. Food prices have soared by nearly 40% since 2007, while businesses and consumers have also had to endure the impact of rising oil and commodity prices, a weakening pound, plus hikes to VAT and tuition fees.

“But it could have been worse. Our modelling shows the MPC were right to stick to their guns, allowing inflation to overshoot and avoid tightening monetary policy. The alternative scenario would have seen interest rates rise by 3.5% in 2011, choking off the recovery even earlier and adding an additional 625,000 people to UK dole queues.”

Petrol will stabilise at 135p per litre this year

The EY ITEM Club says CPI inflation will hit 3% over the summer but, with domestic energy bills and food prices set to rise less than last year, will ease back to 2.5% by the autumn.

In the absence of any escalation in political tensions in the Middle East, the report expects prices at the petrol pumps to stabilise at around 135 pence per litre this year. It’s a similar picture for food. After the sharp rise last summer, wheat and corn prices will continue to drop back, providing there are no unexpected weather related disruptions.

High inflation here to stay

“Don’t expect to see a return to the so called NICE  decade of low and stable inflation,” warns Astorri. “One of Mervyn King’s last acts as Bank of England Governor will almost certainly be a letter of explanation to the Chancellor to explain yet another inflation overshoot. And further out it’s unlikely that the UK will get back to the Chancellor’s 2% target.”
 
The report says that even once temporary factors – such as the rise in tuition fees - have fed through the system, underlying inflationary pressures will have started to build again. As the UK economic recovery continues to strengthen, workers will have greater bargaining power to push for wages increases while businesses will be in a better position to grow their profit margins with price hikes. Rising import prices from the emerging markets are also set to continue, driven by increasing labour costs as their economies mature.
 
The EY ITEM Club is forecasting CPI inflation rates of 2.9% in 2013, before settling at 2.6% in 2014 and 2015.

Winner and losers for UK business

Mark Gregory, EY’s chief economist, says higher inflation will impact profitability if business does not respond effectively. “It is critical to develop a detailed understanding of the likely impact on consumer spending and the future costs of supply to help shape its strategic response. Pricing will be key and businesses must consider acting to increase the average prices paid for their goods and services.”

Continuing, he explains that the energy, rail transport and infrastructure sectors may potentially be beneficiaries, as their prices are often regulated and linked to RPI inflation. “The combination of persistently strong price growth and, in most cases, relatively inelastic demand, is also likely to make these sectors more attractive to investors. But, with consumer spending continuing to be curbed by rising costs and only set to improve gradually, retailers will need to battle harder than ever to win the war for our wallets,” adds Gregory.

MPC’s hands may be tied

Concluding, Astorri says that high inflation over the long term will also create challenges for the MPC. “As well as becoming a risk to the MPC’s credibility, persistent levels of high inflation may tie their hands when it comes to creating a more flexible system.

“As part of their new remit, the Chancellor is keen for the MPC to provide the market with forward guidance, whereby  base rates would remain on hold until intermediate thresholds are met, while maintaining the over-riding importance of the inflation target. But, with inflation still above 2.5%, it’s going to be tough, particularly if the MPC want to follow the US Federal Reserve’s example of only increasing interest rates once unemployment has fallen below 6.5%. Either way, Mark Carney looks set for a difficult tenure.”