United Kingdom: Inflation without benefits

Consumer demand in the United Kingdom remains modest, which we attribute to a combination of factors. These include still curtailed opportunities to spend on goods (stock constraints) and services (social distancing restrictions), an erosion in real earnings, wealthy households’ low propensity to spend and a paradigm shift in spending habits.

We expect falling Covid-19 cases and an ongoing easing of already moderate social distancing rules, including a shorter self-isolation period, and of travel restrictions to shore up already strong employment prospects and further open up opportunities to spend. Supply-side shortages of goods should also ease.

Moreover, sizeable household deposits, which increased by about £259bn (12% of GDP) between February 2020 and November 2021, should help provide a cushion for UK consumer demand.

However, a triple whammy of tax hikes and increase in the British government’s price cap on energy bills in April and likely Bank of England policy rate hikes in coming months will further erode consumers’ purchasing power and poorer households’ ability to spend. Wealthier households’ willingness to spend (rather than invest) is unlikely to make up the difference in our view.

The tidal-wave of consumer spending which many British policy-makers had expected and banked on has simply not materialised and may never fully crystallise in our view.

Year-on-year CPI-inflation, however, will likely rise further in coming months and only fall slowly in our view as a result of elevated cost-push inflation.

So while further Bank of England policy rate hikes may cool a still hot UK property market, they would also at the margin exacerbate cost of living pressures faced by households without having a material disinflationary impact, in our view.

The Bank of England is aware of this “this demand-versus-inflation” dilemma but seemingly does not have a satisfactory solution. At the very least this could result in recently subdued Sterling volatility picking up, a theme we will explore in a future report.

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