The biggest economic issue wracking our country and, indeed, most of the developed world, is sky-high inflation. Inflation is the increase of prices across the economy over time. Inflation, which covers aggregate prices in the economy, is a key contributor to the cost of living. This month, Consumer Price Inflation - which measures the rate of change of an index mirroring a representative basket of consumer goods - hit 9.1%, where the Bank of England’s target is just 2%. Although CPI is still increasing, the ascent is slowing, perhaps presaging a future decrease in inflation. IFS has also noted that inflation has hit the poorest more aggressively than those who are better off, meaning that the headline inflation rate - which is already massive - understates the cost-of-living crisis on the poorest. Low cost food items, as well as basics such as energy and fuel, have seen the greatest increases in price.

Producer Price Inflation, which shows the price increases for inputs for UK manufacturers, remains substantially above CPI at 15.7%. Again, the rate of increase for PPI is slowing (a further sign it may be a transitory shock), though it remains substantially higher than the 14.7% from April. Firstly, this is a bad sign for future inflation, since PPI often feeds through to CPI. It also shows that firms are absorbing some of their costs at present, rather than passing it on to consumers.

As a result of this inflation crisis, the Bank of England has increased interest rates from 1% to 1.25%, the conventional response to high inflation. By making credit more expensive, high interest rates discourage spending in the economy and encourage saving. This reduces the amount of money in the economy chasing a relatively fixed amount of goods, which lowers the upward pressure of prices. It will slow the economy, however, which may tip the UK into recession. The Bank of England will hope to stop the issue with inflation early, whilst it’s less severe, so that the damage to the economy is minimised. It is the fifth successive rate rise. Nevertheless, future rate increases seem quite likely, with the Monetary Policy Committee split over whether a larger rate increase is appropriated.

Partly as a result of these rate increases, as well as other factors such as the war in Russia and ongoing trade disruption, growth forecasts for the UK have become very bleak. The IMF have lowered their growth forcasts for the UK so that it is the lowest in the developed world aside from Russia. The British Chamber of Commerce predict that during this year the UK’s growth rate will be 0%. In other words, the ‘bounce back’ from Covid, so heralded by the Government, has already ended. We are heading towards stagflation - high inflation coupled with low or no growth in the economy.

Inflation has also had a detrimental impact on the public finances. Public Sector Net Borrowing was at its 3rd highest rate for any May since records began. Rising prices, especially on inputs and wages, increases costs to the government. Admittedly, inflation also increases receipts - people are paying record taxes both due to increased nominal incomes and ‘bracket creep’, where inflation causes people to move into higher tax rates. But interest rate rises also raises the cost to the government of servicing the national debt, which is now larger than at any time since the Second World War. We should not countenance and cannot afford a return to austerity economics, but the Conservatives have failed even by this narrow measure of fiscal success.

Earnings increased last month by 6.8% Year on Year, which is a large increase relative to previous months. The increase doesn’t meet inflation, however, meaning that workers’ real terms wages fell, not keeping pace with the cost of living. Such an increase in earnings may also contribute to the permanence of inflation, since if workers demand higher wages, this may ultimately be passed on through prices, causing a wage-price spiral. At the moment, there is not much evidence to suggest that a wage-price spiral is occurring, since wages lag prices and costs exceed inflation. The Bank of England, therefore, still believes the current inflation is transitory, which is promising, though ‘transitory’ inflation could still last a long time and cause damage.

Finally, the Labour Market remains surprisingly healthy. Unemployment is down to 3.8% from recent peak of 5.2%, and thus is now at a historically quite low level. Employment, on the other hand, remains below pre-pandemic levels. This difference is driven by an increase in the number of workers who have become ‘economically inactive’, meaning they are neither in work nor actively seeking work. Some of this is driven by an increase in full time education, but long-term sickness is also at a record high. The current Labour Market is perplexing, ordinarily stagnant growth is associated with high unemployment. Whilst it is obviously a good thing that unemployment hasn’t spiked, the UK’s long term issue with productivity continues to be very concerning, and could cause very severe economic issues in the medium term. Supply chain disruption, falling European migration, and damage from Covid may have mitigated demand-side shocks in recent years by hammering out supply side too. This is good for unemployment, but bad for output, inflation, and our long term growth prospects.

Overall, the outlook over the next few months - and indeed the next few years - is terrible. The Cost of Living crisis may entrench inequalities further, and growth is likely to be sluggish, with concerns predominantly now being on the supply side (which is harder for the government to address). Inflation, whilst hopefully transitory, is a serious threat in the medium term. Nevertheless, education and investment remain resilient to the economic turbulence, so British long run prospects may be better.

This post was authored by Matthew Oulton, Vice Chair of the Young Fabian Economy and Finance Network.

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