The past week’s slew of economic data for the UK gave the latest update on our economic health. Retail sales jumped in April, helped by the Royal Wedding and the good weather. And inflation also surprised on the upside, picking up from 4.0%Y/Y in March to 4.5% in April. The pickup in inflation has led to more calls for swifter rises in interest rates, and concerns about household incomes. But much of the pickup in the headline inflation rate reflected transport services and in particular air fares, which jumped by 29% between March and April.
That sort of jump in prices is bound to raise a few eyebrows. But it turns out that this just reflects the airlines following their usual pattern. Unlike some other products, prices for air travel are highly pro-cyclical in a seasonal sense – meaning that, during periods of peak demand, airlines jack up their fares to take advantage and rake in more money. Anyone who has flown home to see family & friends at Christmas will probably have noticed this; Easter is another time when prices normally jump. The difference this year was that the timing of Easter was later than in 2010 – so, in terms of the year-on-year comparison, prices were higher this year than last. (At the same time, this implies that there might have been some downward pressure on March’s inflation figure.)
Air fares will have fallen back after Easter. But with sizeable increases in electricity and gas prices due to hit consumers in the months ahead, the Bank of England’s prediction that CPI inflation will hit (or exceed) 5% this year looks odds-on. So why isn’t it doing more to get inflation down?
The Bank has consistently argued that much of the inflation we have seen over the past couple of years has reflected one-off factors: sterling’s sharp depreciation in 2007/8, the rise in the oil price, the VAT hikes as the economy emerged from recession, etc. It is probably right. But the problem is that these one-off effects have all gone in one direction – or, in the jargon, they are serially correlated.
The big risk for the Old Lady is that businesses and workers get fed up hearing about the next one-off factor that is due to hit, such as the utility price hike that is coming our way. And, instead of believing the Bank – even though it is probably right – they may start to think that inflation will persist at 4% or 5% for rather longer than it is actually likely to. These informal predictions could then become self-fulfilling if firms decide to increase prices by more, or if workers start to push for higher pay awards to compensate for higher inflation.
There are signs that the Bank has already lost the first half of this battle – various measures of households’ inflation expectations have been above the 2% target for some time. So the Old Lady is at least partly relying on competition to restrain greedy firms, and on unemployment to restrain wage growth. The implicit gamble is that even if workers push for big pay increases firms will hold the balance of power and resist them, given the large pool of available labour that is still very much out there. Hot on the heels of the inflation figures was the latest update on the labour market. It was decidedly less exciting, but still suggests that there are just under 2.5mn people actively looking for work. If you add on those people who can’t start straight away but would like a job, and all those forced to take temporary or part-time work that they didn’t want, the total would be even larger. That spare capacity in the labour market should continue to bear down on wages.
The Bank would never openly say that high unemployment was a good thing – indeed, in a broader context it most definitely isn’t. But the fact remains that, without joblessness more than keeping wages in check, interest rates would probably have already started to rise. The Old Lady continues to face a tricky balancing act between trying to support growth, which should eventually bring unemployment down, and making sure that underlying inflationary pressures remain contained.