The cost of living problem

The biggest economic surprise of 2021 was the resurgence of inflation. This was largely unforeseen at the start of last year and even by the spring was still not expected to become a significant problem. Thus the news that global inflation has hit multi-decade highs is an unwelcome development for households who have to deal with the fact that prices are increasing much more rapidly than wages and central banks who have to decide how to respond.

People aged 30 or younger were not even born the last time European inflation rates reached current levels. Data for December showed the German inflation rate at 5.3% – the highest since 1992, which was also the same year CPI inflation in the UK last exceeded the December reading of 5.4%. We have to cast our minds back to the era of Paul Volcker for the last time the US inflation rate exceeded the 7% rate posted in December (1982, for the record). Those who thought high inflation was a thing of the past have had an uncomfortable awakening in recent months. This is attributable to a combination of global supply bottlenecks in the wake of the pandemic and rising energy prices, both of which are likely to prove temporary (although temporary could mean anything up to two years). Both these elements were encapsulated in the UK data for the transport component of the CPI, which accounted for almost one-third of the annual inflation rate last month. The cost of vehicle purchases rose by 13.9% in the year to December with shortages of key components pushing up prices, whilst fuel costs were up 26.6% on the back of higher oil prices.

UK inflation is set to go higher still when the domestic energy price cap is raised in April. This sets a limit on the maximum amount suppliers can charge customers for each unit of energy consumed. The new cap will be announced in February but is expected to rise by anything between 46% and 56% on the basis of recent trends in wholesale energy prices. Other things being equal this may be enough to push CPI inflation close to 7% in Q2 (chart below). For the record, the BoE’s November forecast pointed to an inflation rate of 4.8% in the second quarter: we can expect a significant upward revision when the new forecast is released next week.

A cost of living “crisis”

All this has given rise to lurid headlines about a “cost of living crisis” and the possibility that many UK households will be pushed into fuel poverty, officially defined as above average fuel costs that push their residual income below the poverty line (a rough rule of thumb adopted in Scotland, Wales and Northern Ireland is that a household suffers from fuel poverty when it spends more than 10 per cent of its income on fuel). The poverty campaigner Jack Monroe made the point in a Tweet that subsequently went viral that the index used in calculating the cost of living “grossly underestimates the real cost of inflation” using the case of rising food prices as an example.

This is both right and wrong. It is right because the CPI is calculated on the basis of average spending shares on particular categories of goods and services, but these differ according to income. Thus if prices rise more quickly for those categories where poorer households have a high spending weight, the average CPI inflation rate will understate their “true” inflation rate. But that was not the case in 2021. I am indebted to the calculations by Chris Giles, which I have attempted to replicate, which demonstrate that price inflation has been higher for households at the upper end of the income scale because their spending basket has shown a faster inflation rate than for those lower down the scale. On my calculations, the inflation rate for households in the lowest income decile was 5.3% in December versus 5.8% for those in the highest decile.

None of this is to say that we can ignore the distributional aspects of inflation. The rise in the energy price cap will almost certainly hit households at the low end of the income scale disproportionally hard. This raises a question of what, if anything, should be done about it? The financial market response is clear – central banks should raise interest rates, and they probably will, but it is unlikely to have any impact on a supply-driven inflation shock. Indeed central bankers find themselves in an impossible situation. If they don’t raise rates at a time when inflation is overshooting target by a wide margin, the future credibility of inflation targeting regimes will be compromised. Against that, if consumers are facing a cost of living crisis in which real income growth is being eroded by exogenous price shocks, monetary tightening is more likely to exacerbate these concerns.

As MPC member Catherine Mann pointed out in a speech last week, the evidence suggests that the recent inflation surge is not based on a narrow range of goods and services but is increasingly looking more broad-based and “has seeped into those [components] that typically are rather stable.” She also pointed out that “Bank research shows inflation expectations tends to be correlated with wage demands, and that items that consumers buy frequently, such as energy, food, and clothing have particular salience for their short-term perceptions of inflation.” A gradual tightening of monetary policy to offset the threat of a wage-price spiral would thus appear to be a prudent move.

Alternative ways to tackle the energy inflation problem

However, it seems clear that monetary policy is only going to be part of the solution in the near-term. One temporary fix to offset the inflationary impact of higher energy prices might be to zero-rate domestic fuel bills for VAT purposes (in the UK it is currently charged at a rate of 5%). It would come as no surprise if this measure were to be announced in the spring budget in March. Another option might be to remove the green levy on household fuel bills, and instead fund them out of general taxation. At present, the Energy Company Obligation (ECO) requires medium and larger energy suppliers to fund the installation of energy efficiency measures, which is charged back to the consumer via their energy bills (primarily electricity). Permanently scrapping the ECO would obviously reduce energy bills, and thus inflation, but would require an increase in taxation elsewhere to fund the shortfall. This problem could be mitigated if the ECO were scrapped for just a year.

One downside with these solutions is that they would benefit both poor and wealthy households and do little to tackle inequality issues. Amongst the alternatives that have been floated are the extension of existing government-funded support to those on means-tested benefits or simply restoring the uplift to Universal Credit that was put in place during the pandemic but taken away in October. Whilst these measures will do nothing to tackle rapid price inflation in other areas they may help to avoid the worst case outcomes in 2022.

Unpleasant choices ahead

Nonetheless, we are likely to be faced with a series of unpleasant choices in the months and years ahead and tinkering with the tax and benefit system is unlikely to resolve them. On the one hand we will likely have to face up to higher taxes as governments attempt to claw back some of the fiscal costs associated with the pandemic. As it is, UK national insurance rates are set to rise in April, at the same time as the energy cap is due to increase. There is also a wider issue associated with the transition to green energy sources. If we are serious as a society about making this transition, there will be a price to pay and consumers will ultimately have to bear it.

Although the pressures on consumer incomes are particularly great at present, and will undoubtedly diminish with time, we may not return to the nirvana of strong income growth and low price inflation anytime soon (at least, not without a recovery in productivity growth to something like pre-2008 rates). The transition to the post-Covid economy may prove to be more painful than anticipated.