Inflation Spike tops a ‘Dangerous Cocktail’

Inflation Spike tops a ‘Dangerous Cocktail’
June 16, 2017 Mark Richards

Inflation Spike tops a ‘Dangerous Cocktail’

Inflation rose again in May, putting more pressure on our disposable income. Ultimately this could turn out to be very bad news for the UK economy 

There was good and bad news when the Office for National Statistics (ONS) revealed the figures on employment and inflation earlier this week. First the good news: unemployment fell by 50,000 to 1.53m in the three months to April – that is the lowest since records began in 1975. Meanwhile, the number of people in work continued to rise with the employment rate (the proportion of people aged 16 to 64 who were in work) rising to 74.8%, the highest figure since those records began in 1971. Even better, the ONS revealed that the number of job vacancies was also up – rising by more than 9,000 since February.

So far, so good – but any national ‘feelgood factor’ was wiped out by the news on inflation, and the impact that the rise in inflation has had on real wages.

The inflation figures

Inflation was up to 2.9% in May – an increase on the 2.7% that was recorded in April and well above the Bank of England’s target rate of 2%. In real terms, this means that wages have fallen. Year-on-year wages were up by 1.7% excluding bonuses and by 2.1% including bonuses: but factor in inflation at 2.9% and there has been a general fall in the real value of your take home – which has been even worse if you are in the public sector, where workers have only received a 1% pay increase.

Various commentators were not slow to voice their opinions on these figures. John Hawksworth, chief economist at the accountants PwC said that the most striking thing about the figures was the clear evidence of a squeeze on pay, especially in the public sector.

“With inflation likely to go above 3% later this year the squeeze on real pay is likely to dampen consumer spending.”

He then planted his flag firmly in the ‘Remain’ camp by adding,

“The cost of Brexit to people’s living standards – due to the fall in the pound – is becoming ever more apparent.”

He was supported in this view by the TUC although – hardly surprisingly – the focus of their ire was the Government. General Secretary Frances O’Grady said,

“Unless the government gets its act together we’ll soon be in the middle of another cost of living crisis. Ministers must focus on delivering better-paid jobs across the UK.”

So why has inflation gone up?

Inflation is measured using a notional ‘basket’ of goods and services, with items being included or omitted depending on their popularity. Inflation went up in May thanks to increases in the price of foreign holidays and imported computer games. You might argue that computer games are not essential to human life (in which case you have never had a teenage son…) but they are in the inflation basket as part of the ‘recreational and cultural goods and services’ sector. Although fuel costs came down in May, other increases – in food, children’s clothes and furniture – saw inflation increase again to 2.9%.

Is this because we are leaving the EU?

Is inflation spiking because we are leaving the EU?

Following the ‘Leave’ result in last year’s Referendum sterling fell sharply – in very round terms, the value of the pound fell from $1.50 to $1.30. That means something which previously cost £100 to import suddenly cost £115 to import. More than half of Britain’s food now comes from abroad. Do you want strawberries in February? No problem, they will be flown in. But as the pound falls, so the price of those strawberries and all imported food increases. If you want another example, go and buy a large jar of coffee for the office…

However, it is not just a one-way street: a fall in the value of the pound is good news for exporters, as their goods are now more affordable in foreign markets. If food going up is the bad news from the pound falling, more jobs being created in manufacturing and exporting is the good news.

Is that it? Or will inflation increase again?

Sadly, it does not look as though it will stop there. Inflation is expected to increase further this year, with forecasters now expecting it to go above 3%. It was only in March that the Bank of England forecast a maximum level of 2.8% for the year so the signs do not look good. Amit Kara, head of forecasting at the National Institute of Economic and Social Research said,

“This spike in inflation will exert further downward pressure on real household disposable income, while wage growth remains modest. It will further squeeze consumer spending.”

The cheerfully-named Samuel Tombs, chief UK economist at Pantheon Macroeconomics, suggested that inflation looked set to peak at 3.2% in the fourth quarter of this year, “as retailers continue to pass higher import prices on to consumers.”

Why does this matter?

It matters for three reasons. First and foremost people are simply going to be worse of, whether they are working or in retirement. In fact, those people on fixed pensions are going to be hit particularly hard if inflation continues. The same applies to benefits, with previous Chancellor George Osborne having frozen ‘working-age’ benefits: if you receive child benefit, tax credits or jobseeker’s allowance your benefits no longer increase with inflation.

Last year inflation was close to zero – but with the rate now increasing the real value of wages is dropping, and the value of fixed incomes like pensions and benefits is dropping even more sharply. People, therefore, have less money to spend – which takes us on to the second reason this is so important…

Consumer spending drives UK economic growth – it accounts for approximately 60% of all our economic activity. So if consumers cut back on spending – simply because they cannot afford to spend – that can very easily lead to an economic downturn. Theresa May famously walked into Downing Street (the first time) promising to help those who were ‘just about managing.’ But it is exactly those people who will be hit hardest by this latest rise in inflation and the consequent squeeze on wages.

Ben Brettell, a senior economist at Hargreaves Lansdown, said,

“The UK economy faces a dangerous cocktail of political uncertainty, slowing growth and shrinking real wages. The squeeze on household incomes continues to get worse.”

Finally, inflation weakens companies’ ability to invest: forecasting the cost of doing business – both buying raw materials and paying wages – becomes more difficult, and hence companies are more reluctant to commit to the investment. That leads to the slowing growth mentioned above: throw in the current political turmoil, the uncertainty of Brexit and continuing concerns about world trade and ‘dangerous cocktail’ may prove to be an understatement…

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