The UK upgrades its economic outlook as inflation fears loom
Updated: Jul 12, 2021
After lockdowns stifled growth at the start of the year, the economic outlook has improved significantly across the UK. Economists now predict that the early effects of the pandemic will be fully recovered by the end of next year. Inflation, however, is becoming a rising concern, permeating nearly all industries at a rate that some economists and investors consider worrying.
The UK economy is expected to grow at its fastest rate since World War II this year and in 2022, according to the Organisation for Economic Co-operation and Development (OECD). Following the devastation caused by the Covid-19, the UK experienced a 9.8 per cent contraction in 2020 — the worst in nearly 300 years.
The organisation anticipates a GDP growth of 7.2 per cent this year and 5.5 per cent in 2022. This would put them ahead of other advanced economies, including the United States. The OECD predicted UK growth of 5.1 per cent this year in March.
With lockdown measures being progressively eased and the economy reopening, the positive outlook for the UK this year reflects the critical role that the vaccination programme is playing in supporting economic recovery. However, because of the ongoing impact of Brexit, the OECD forecast predicted that the country’s post-pandemic rebound would be slower than that of many other rich economies.
“The United Kingdom could suffer the biggest reduction amongst G7 countries (a decline of 0.5 percentage point per annum), in part reflecting the additional adverse supply-side effects from 2021 following Brexit,” the OECD said in the report.
As the economy continues to get back on track, the annual rate of inflation in the UK more than doubled in April to 1.5 per cent, thanks to higher gasoline prices and gas and electricity bills, reaching its highest level since the start of the pandemic. Officials from the Bank of England said such a surge was expected since it would largely reflect a return to normalcy after the rate had been artificially reduced by extraordinarily low petrol and energy prices over the past year due to the coronavirus pandemic.
After non-essential shops reopened in April and hospitality establishments were allowed to serve clients outside, prices for eating out in restaurants, staying in hotels, and buying clothes all rose substantially. The increase in the consumer price index, up from 0.7 per cent in March, met the expectations of the Bank of England, which expects inflation to peak at 2.5 per cent by the end of the year and then return to target over the next few years.
The Bank of England's governor, Andrew Bailey, told parliament on May 18 that he was examining the statistics "extremely carefully" for signs of a sustained overshoot in the bank's target, and that if risks emerged, he would not hesitate to tighten monetary policy by raising interest rates. This would result in higher financing costs, a slowdown of the economy and would make it more difficult for businesses to pay off their Covid-19 loans.
The official numbers also revealed that the rate of inflation was only maintained as low due to a temporary 5 per cent value-added tax on hospitality, which will stay until the end of September. If taxes were kept at their regular levels, inflation would have risen to 3.2 per cent — the highest rate for nine years.
The current general agreement is that price increases in commodities and goods markets have clear pandemic-related justifications and that the likelihood of a worldwide inflation revival similar to the 1970s hyperinflation is low.
“Supply chains have been broken, a few restaurants have been shut for nine months and are now reopening,” Huw Dixon, economics professor at Cardiff University and coordinator of the Centre for Price and Inflation, told this reporter. “These are adjustment processes that will probably work their way through in a few months or so, they won't be here forever.”
Although mainstream policymakers are remaining calm, financial market expectations of inflation have risen sharply in 2021 as a result of fears about price hikes in key economies such as the US and the Eurozone.
Higher inflation in the US, with CPI at 4.2 per cent over the 12 months ending April, the highest since the global financial crisis of 2007-09, offers a different picture than in the UK after more significant stimulus. Inflation in the eurozone reached 2 per cent in May, exceeding the European Central Bank's target for the first time in more than two years.
In a research report, Samuel Tombs, chief UK economist at Pantheon Macroeconomics, said that the UK is not yet showing the worrying signs of a significant increase in inflation as have been observed in the US. He believes that rising unemployment when the furlough scheme ends and weak pay growth will keep inflation in check.
“Whenever the financial markets see big fiscal packages like the furlough scheme or stimulus checks, they immediately think that inflation is coming back and expect an increase in nominal interest rates,” Engin Kara, economics professor at Cardiff University told this reporter. “But there was a similar expectation just after the 2008 crisis and that didn't happen.”
But a growing minority see the beginnings of a sustained period of rising inflation. “We do not believe that higher inflation will be fully transitory as many in markets contend and as global central bankers seem to presume,” Berenberg Bank’s Kallum Pickering told Reuters. “The rebound marks a turning point for inflation across the advanced economies following more than a decade of disinflation.”
Concerns over inflation also include the effects of the UK’s exit from the EU at the start of this year. The January 2021 Centre for Macroeconomics survey asked members of its UK-based panel their inflation predictions for the next 10 years. Responses pointed to Brexit as the most common inflationary threat in the first half of the decade.
“Brexit has put upward pressure on costs, which will ultimately result in higher prices,” Thorsten Beck, professor of banking and finance at the Cass Business School in London, told the Centre. “Population decline due to emigration of EU citizens will cause upward pressure on wages and ultimately prices, e.g., in agriculture and services.”
Central banks have consistently over-forecast inflation and under-shot their targets for more than a decade. Inflation spikes, such as the one seen last month, have usually proved transitory. But the political and regulatory adjustments brought by Covid-19, as well as longer-term changes in the global economy, paint a very uncertain picture on whether this decade could be more inflationary than the last.