Wrong policy decisions may play a key role in Britain's high inflation rates

Britain is in a tight spot. Inflation in the country is the highest in the G7 and it is not budging.

Since 2022, the global economy has experienced a cycle of climbing inflation not seen for forty years. Disruptions to supply chains due to the pandemic and constrained energy supply due in part to the Ukraine war are some of the key drivers of this runaway inflation.

However, compared to the rest of the G7 and indeed the wider Eurozone, Britain's inflation problem is proving especially difficult to tackle.

Respected economist, Mohamed El-Erian, took to Twitter yesterday, comparing the recent UK rate increase with central bank decisions elsewhere.

As he noted, the US Federal Reserve held steady at a rate of between five and 5.25 per cent. Although the Fed expects rate increases later in the year, it is noteworthy that the latest announcement came against a backdrop of falling inflation in that country.

The UK figures for inflation remained unchanged month-on-month at 8.7 per cent for May, frustrating market expectations of a slight fall.

Elsewhere, whilst both Norway and Australia raised interest rates, the resulting rates are much lower than in Britain at 3.75 and 4.1 per cent respectively.

One of the more thorny contributing problems in Chancellor Jeremy Hunt's in-tray is worker shortages. Whilst other economies, notably the US, have also struggled with worker shortages, the problem is particularly acute in Britain.

Post-pandemic, many workers have left the labour force including through early retirement or illness. Before that, Brexit caused many EU-origin workers to leave.

Critics have pointed out that the government's post-Brexit policies on trade and immigration have dampened competitive pressures that would have brought inflation down more rapidly.

This has created a supply-side inflation phenomenon whereby increasing wages, amongst other things, have fed into increasing prices, and thus inflation. However, the minutes from the June meeting of the Bank of England monetary policy committee note that wage increases have been concentrated in higher-paid sectors.

Annual Average Weekly Income has increased by 0.5 per cent to 7.6 per cent in the three months to April. This increase is concentrated in sectors such as financial and business services.

The report went on to say that pay in lower-compensated sectors such as wholesaling, retailing, hotels and restaurants had been broadly flat.

As the Bank of England tightens monetary policy, this means that those in already lower income brackets will bear more of the economic burden.

Whilst energy bills are a big part of the problem in the UK, which relies heavily on natural gas for its electricity supply, there are other issues at play too.

Services inflation is particularly high – and an indicator of domestic problems. Core inflation, which strips out volatile energy and food prices, has been consistently high.

There is a supply-side bottleneck in the economy because demand was inflated in the recent past. Specifically, Britain stood out amongst its peers in terms of the size of the economic stimulus it gave to combat the pandemic, and then again, to combat the energy crisis.

Critics add that the Bank of England – in other words, those who determine monetary policy – has also been slow to act. According to The Economist, the Taylor Rule for monetary policy, which guides the level of interest rate given the rate of unemployment and core inflation, predicts that following the latest rate rise, the current rate should have been 5.7 per cent.

Whilst noting month after month that inflation has outstripped its expectations, the Bank of England has been too cautious in its approach.

Unfortunately, the prescriptions for tackling the persistent inflationary problem in Britain are not pleasant. Put simply, as Karen Ward, an economist and member of the chancellor's council of advisors, has said, only when the public feels the pain will interest rate rises have the desired effect.

Only when wages do not increase, in response to rate rises, can prices stop rising. In her words, the Bank of England has to "create a recession" partly to combat a potential wage-price spiral.