Ever since the start of this year, the Bank of England has underestimated the rise in inflation. As recently as May, it thought the annual rate of inflation might peak at 2.5 per cent around the end of 2021, with it averaging 1.9 per cent in the third quarter.
The data on Wednesday, showing inflation rose to 3.2 per cent in August and was likely to exceed 4 per cent by the end of the year, will require some rapid reconsideration at the BoE.
It needs to set monetary policy to facilitate the economic recovery from coronavirus as much as possible without allowing inflation to become ingrained into wage demands and price increases.
Financial markets expect the first rise in interest rates to come in the first quarter of 2022. Before its meeting next week, these are the five big questions facing the BoE.
1. How temporary are the price rises in the UK?
Every central banker’s fear is that higher inflation at first looks innocuous before becoming dangerously difficult to control. Andy Haldane, the now departed BoE chief economist, warned in June that “time and again” in the past “localised price pressures turned into generalised price pressures and those temporary spikes in prices morphed into more persistent rises in prices”.
Many economists have pointed out that the 18.3 per cent annual rise in second hand car prices reflects a global shortage of semiconductors; a significant part of the August jump in the inflation rate was caused by lower restaurant prices last year in the “eat out to help out” craze; and oil prices are unlikely to keep rising forever.
But with wholesale gas and electricity prices hitting records, energy prices will rise further, with inflation therefore likely to be stickier at high levels. Allan Monks, UK economist at JPMorgan, said it was important to recognise that “price momentum is continuing to surprise” and this would keep inflation higher in 2022 for longer. He does not expect it to fall below 3 per cent until October 2022.
2. How strong will spending prove in the months ahead?
The BoE believes that the underlying forces governing inflation are linked to the level of spending in the economy and the ability of suppliers of goods and services to meet that spending.
The good news here for the BoE is bad news for the recovery, which stalled in July as the Delta variant of coronavirus hit the UK. The Monetary Policy Committee will need to judge whether this was a temporary shock or more permanent.
Andrew Bailey, BoE governor, is content that the recovery is not accelerating out of control. “We are seeing some levelling off,” he told MPs this month, suggesting this would lessen concerns about inflation.
The MPC will need to reassess at its meeting next week because the latest data has been somewhat stronger. Marchel Alexandrovich, European economist at Jefferies, the investment bank, said on Wednesday that its latest evaluation of real-time data showed that economic activity was within 1 per cent of pre-pandemic levels.
“Another material rise in [traffic] has pushed the headline closer to a full recovery, with the continued support from hiring activity also notable,” Alexandrovich said.
3. How serious and persistent are supply bottlenecks?
If spending is one side of the coin, the other is the ability of the economy to supply goods and services to match demand without higher prices.
Empty shelves, fruit rotting in fields and care homes desperately short of staff have highlighted the potential for the supply of workers and skills not to be well matched by demand in the months ahead, leading to the possibility of more widespread wage and price increases even with the end of the furlough scheme this month.
Semiconductor shortages, undermining production in the automotive sector, are unlikely to be resolved quickly and UK producer price inflation rose to 5.9 per cent in August.
Kallum Pickering, UK economist at Berenberg Bank, said such “supply pressures are intensifying and may last well into next year”.
Bailey appears to agree, telling MPs that he was concerned that the current difficulties of matching people to jobs would persist.
4. Will low unemployment drive wage increases?
The BoE is not concerned about higher wages if these were matched by more goods and services being offered. But it worries about inflation if companies have to raise prices just to pay more to attract employees.
The latest labour market indicators showed vacancies at record levels and employment having risen to pre-pandemic levels. There are still more than 1m people on furlough and the former self-employed to restrain wages, but the Office for National Statistics estimated this month that underlying annual wage growth was somewhere between 3.6 per cent and 5.1 per cent.
Rather unhelpfully for the BoE, the bottom and top end of this range span the difference between wage growth that is of no concern and something that needs attention.
Martin Beck, senior adviser to the EY Item Club, said the outlook was still relatively good from an inflation perspective. “A boost to the supply of workers, post-furlough, could ease pay pressures,” he said. “And the economic literature suggests that much of next April’s rise in employer national insurance will ultimately be passed on to workers via lower wages.”
5. Will the BoE still be trusted to keep inflation under control?
Financial market expectations of inflation in three years’ time rose 0.23 percentage points since the MPC’s last meeting to stand at 3.75 per cent for the retail price index measure of inflation, a level that would suggest some lack of confidence in the BoE hitting its 2 per cent target on the consumer price measure.
The regular Citi survey of household inflation expectations showed households expected prices to rise annually by 3.5 per cent over the next five to 10 years, up 0.4 percentage points since March.
None of this is conclusive evidence that the public are losing trust in the BoE to control inflation, but the figures will reduce comfort levels in Threadneedle Street.
Janine Boshoff, an economist at the National Institute of Economic and Social Research, said: “Since headline inflation will remain above the Bank of England’s 2 per cent target in the short-term, the bank’s future communications around . . . [interest] rate normalisation will be crucial in preventing a possible dislodging of inflation expectations.”