The inflation cycle won’t break itself

Because most of us have no recollection of a similar time, we assumed it would be over soon. However, this has not been the case.

Prices have been rising steadily since the end of the pandemic, reaching heights not seen in decades and with no signs of abating. 

The worst core CPI reading in the UK since 1992 confirmed the fears of policymakers: that inflation has become entrenched.

Initially, inflation was a result of supply chain dysfunctions wrought by the pandemic and deemed 'transitory'. However, the war in Ukraine thrust food and energy prices much higher.

This propelled consumers and workers into action, catalysing the transformation of inflation from supply driven to a much more dangerous variant: demand driven. The difference is stark.

Supply vs demand

Supply chain disruptions are a problem that can be resolved by concentrated action from supply chain managers. If a good does not reach a desired market via route A, another route B is designed and implemented.

Demand-driven inflation, however, is essentially a vicious circle.

As prices rise, employees go to their managers asking for more money. They are likely to get it because the UK labour market is extremely tight.

Corporate managers have to make sure that their margins are maintained, especially if they have to answer to shareholders. So, they increase the prices of their goods.

Because everyone is affected, this is not confined to companies with pricing power, but it happens across industries. Seeing the rise in prices, consumers, who are also workers, go to their managers asking for another rise.

Inflation is persistent because it has become a game of pass the parcel.

Meanwhile, mortgage rates go up. Because housing availability in certain areas of the country is limited, homeowners have the option to rent out, either the whole property or part of it.

In some cases, renting out a room may be enough to pay for the whole mortgage. Renters, in turn, ask for a raise to cope with increasing housing costs.

Inflation is persistent because it has become a game of pass the parcel. From employers to employees back to employers, from homeowners to renters to employers and back to the market, everyone is trying to pass on the short-term pain, accelerating the inflation cycle.

Taking a share

So how does the inflation cycle break? A known weakness of capitalism is that everyone is incentivised to look after themselves. This can be damaging in times of crisis. So the only palatable alternative is for the state to step up.

On April 25 the chief economist of the Bank of England, Huw Pill, broke form and made an exasperated plea: "Somehow in the UK, someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether higher wages or passing the energy costs through on to customers.

"And what we’re facing now is that reluctance to accept that, yes, we’re all worse off, and we all have to take our share."

All this means more unemployment, less money for consumption and lower living standards across the board.

The furore the comment caused was expected in the age of social media and so was the ensuing apology over the choice of words. But this does not diminish the central bank’s determination to justify its mandate and fight inflation.

The only way they can do this is to make money more expensive and scarcer to drive down demand.

The use of words 'drive down demand' is ‘econospeak’ for a process that is outright ferocious.

Interest rates

In its June meeting, the central bank surprised markets by producing a double rate hike. Higher interest rates increase the cost of mortgages. Currently, the interest rate is at 5 per cent – markets expect it will go as high as 6 per cent by 2024.

According to think tank Resolution Foundation, a 6 per cent interest rate would result in a £2,900 increase in average mortgage payments throughout the country, reducing available incomes.

Higher interest rates result in higher savings rates as well, increasing the incentive to save and decreasing the incentive to spend. This would drive down consumption.

Companies with problematic business models that have relied on a decade of cheap money to keep going, will now be faced with severe difficulties in refinancing.

When all is said and done, the inflation cycle will not break itself.

Those businesses will find it hard to raise wages. Some might even have to close doors, forcing unemployment up and relieving the stress in the labour market.

All this means more unemployment, less money for consumption and lower living standards across the board. A recession is quite possible.

Chancellor Jeremy Hunt said on May 26 that he would be comfortable with a recession triggered by the BoE if that is what it takes to break inflation and return to growth.

When all is said and done, the inflation cycle will not break itself. Policymakers are gearing up for a war on prices. An inflation fight comes at a great cost. It requires swift and decisive action and involves a good deal of economic pain.

Businesses and consumers should prepare for one of the most difficult economic years in living memory.

George Lagarias is chief economist at Mazars