By Michael Burke
The latest monthly data show the annual pace of UK inflation accelerating to 4.5% in April, using the Consumer Price Index (CPI). The broader measure of inflation in the Retail Price Index (RPI), which also includes housing costs moderated a little, to 5.2% from 5.3% in March.
The impact of these prices increases is severe. At the end of 2010 the annual level of all wage compensation in the UK economy totalled £800bn. In the February data, average weekly earnings grew by just 0.9%. If sustained the decline in real wages would therefore amount to 4.3%.
For comparison if a decline of 4.3% in real wages were directly translated into total employees’ compensation it would amount to a £34bn annual reduction in incomes. This compares to the government’s already enacted tax increases of £3.8bn and spending reductions of £5.5bn in the previous Financial Year (FY) and £20bn in taxes and £22bn in cuts in this FY.
Unlike the impact of spending reductions on public services, inflation affects all sectors of society, especially those on low or fixed incomes, in addition to those in the public sector who are seeing their pay fall through a wage freeze and increased pension levy.
Usually the group on fixed incomes would include those receiving the state pension. However for reasons of political calculation, the government has chosen to offer a ‘triple-lock’ on pensions, so that pensioners will receive the highest of earnings growth, the RPI or 2.5%. However it was hardly envisaged at inception that this could mean a future pensions increase of 5-6% just to keep pace with the RPI. Both the June 2010 and March 2011 Budgets assumed that there would be no additional cost to this policy in the current FY. But if the overshoot in inflation is in line with the Bank of England’s latest quarterly Inflation Report, then the cost to the Treasury will be £2.9bn in this year alone – without leaving pensioners any better off.
If the real aim of policy was to reduce the budget deficit, the government approach would be utterly self-defeating. The rise in pensions and other welfare benefits (although most of these have now been switched to a link with the persistently lower CPI) automatically triggered by higher inflation will cause significant increases in net government outlays, even while entitlements are being cut back
Yet government policy is itself largely responsible for the overshoot in inflation. The chart below is taken from the latest official publication for the Office for National Statistics (ONS). In addition to CPI inflation, which is currently at 4.5%, two other measures of inflation are shown. The CPIY measure shows price increases excluding the direct effect of changes to indirect taxation, such as VAT. This is currently rising at a pace of 3%. The CPI-CT measure is the same as CPI but is adjusted as if all taxes were unchanged during the latest 12-month period (for example, excise duty rose on alcohol and tobacco in the March Budget and these are excluded). This is currently rising at a pace of 2.8%.
Figure 1 – CPI and CPIY % change:
The Bank of England’s medium-term target is a 2.0% inflation rate with a tolerance zone 1.0% either side of that central aim. A large part of the current overshoot is a direct effect of government policy, which will also have greater indirect effects too. On both the CPIY and CPI-CT measures which exclude the direct effects of government policies, the inflation rate would be within the target range.
This matters primarily because both the latest data and the Bank’s Report have raised expectations that there will be interest rate increases before the end of the year. At the time of writing the interest rate futures market was pricing in two rate hikes by year-end to take official rates up to 1%.
Government hopes for economic recovery are largely pinned on the ability of very low interest rates to support borrowing by companies and especially households while the public expenditure reductions are pushed through. If the prop of low interest rates is kicked away the economic outlook will deteriorate sharply. Yet it is in the government’s own hands to lower the inflation rate by reversing the rise in VAT. They could also reverse the rules that allow permanent above-inflation prices rises for the privatised utilities and rail companies, which are set to lead to price rises of up to 14% later this year .
At the turn of the year higher inflation led to calls for significant rate increases and a campaign for a higher pound which the Chancellor and Prime Minister were keen to lead. Sterling climbed sharply, as Figure 2 below shows.
Figure 2 – £, December 2010 – May 2011