Deflation Likely on Its Way for the UK
Deflation Likely on Its Way for the UK
While the UK narrowly avoided a recession in 2022, deflation now appears likely to be on its way for the UK. Low and stagnant growth is hurting the economy due to its structural challenges that policymakers have overlooked while pushing up interest rates.
The wage pressure driven by inflation, the cost of living crisis, the UK’s ageing population, and the current state of the labour market puts the country in a difficult position. However, consumer confidence appears to be rising in 2023 as lower incomes experience a wage increase, while those on upper-middle-income are the most impacted by inflation.
Middle-income households have been exposed to mortgage increases due to interest rate inflation. They have received limited government support and are typically facing higher exposure to lower wage increases with a higher risk of redundancy.
The UK’s inflation jumped to 10.4% in February after three months of gradual declines from the country’s peak at 11.1% in October 2022. It’s worth remembering that the Bank of England’s inflation target is 2%. Most economists in January were largely rallying around the sentiment that inflation would fall faster than expected in January prior to the jump in February
It appears that deflation is likely on its way for the UK with outright price deflation forecasted by the government’s budget watchdog within the next three years. This forecast calls into question the Bank of England’s continued increase of interest rates and poses the question of whether it is policy overkill.
The Bank of England itself expects inflation to fall “quite sharply from the middle of this year”. The current inflation rate remains over double digits at 10.1%.
The likelihood of deflation making its way to the UK this summer suggests that an increase in the Bank rate would be policy overkill.
Bank of England consistently overestimates inflation forecasting
The Bank of England has consistently overestimated its inflation forecast. When we bring in third-party forecasts to balance the picture, the graph becomes more negative.
Low to zero growth is expected to continue for at least 12 months, while the UK economy will not experience a technical recession. Several factors have eased the downward pressure on the UK’s GDP forecasting. The Bank Rate peaked at 4.5% instead of the forecasted 5.0%.
The economy stabilised after Sunak was appointed Prime Minister with interest rate spreads reducing as a result.
There are global factors that are also likely to have a knock-on effect on the UK’s inflation. China’s recent changes to its COVID policy will finally relieve supply chain concerns for various industries.
While unemployment levels are remaining relatively low at an average of 3.7%, labour shortages are continuing to persist since the beginning of the pandemic with a sharp increase in inactivity amongst the working-age population. Long-term sickness, including long covid, is one of the biggest drivers of economic inactivity, accounting for 60% of its increase.
Inflation remains in double figures
Deflation is also more likely with supermarkets beginning to price cut in a bid to push down food price inflation. Tesco is leading the way after research by Kantar suggests that grocery price inflation has reached 17.5%, adding over £800 to the average household’s annual food bill.
The supermarket chain is expected to push its suppliers to cut prices to pass on lower prices to consumers in the coming months. Tesco’s actions come as inflation begins to fall as energy and gas prices return to their prices before Russia’s invasion of Ukraine.
The UK’s inflation rate remains in double figures at 10.1% in March 2023, falling by less than expected. Economists had expected inflation to fall back into single figures at 9.8%. Economists expect the Bank rate to potentially hit 5% in autumn if inflation remains in double figures.
Tesco’s actions in pushing to reduce food costs are significant as the lower-than-expected fall in inflation was largely due to inflation for food and non-alcoholic drinks. Both saw a jump of over 19% in price from March 2022 to 2023. Food such as ready meals and hot beverages saw their fastest annual rate rise since comparable records began in 1989.
Silvana Tenreyro predicting significant inflation undershoot
The Bank of England may now need to cut interest rates earlier and faster. Silvana Tenreyro, an MPC member, expects that deflation is on the cards with signs pointing towards inflation falling well below the Bank of England’s 2% target rate following the sharp decline in global energy prices.
She also points to the impact of previous increases on the economy. Tenreyro is a member of the Monetary Policy Committee (MPC) at the Bank of England. She used a speech at the Royal Economic Society’s annual conference in April to call for a “faster reversal (to the high current level of Bank rate) …to avoid a significant inflation undershoot”.
Tenreyro voted to keep the Bank rate at 4% in March when it was raised to 4.25% by the MPC. She also pointed to the loosening bottleneck of supply chain disruption caused by the pandemic occurring at the same time as the energy market begins to stabilise itself.
Although oil prices have increased, energy prices are significantly lower than the peaks seen in the direct aftermath of Russia’s invasion of Ukraine in the spring of 2022. The wholesale market price for gas has also fallen from its post-invasion peak.
Tenreyro points out that this drop is quicker and sharper than the Bank of England had anticipated. Shipping costs and supply chain disruptions have now largely returned to their pre-pandemic levels.
Over-restriction leads to the danger of swing to deflation
Some commentators have been too quick to draw comparisons between today’s economic uncertainty and the 2008 financial crisis. While stagnation is expected to be more prolonged than in 2008 with real incomes facing a larger decline, unemployment will remain significantly lower.
The Bank of England raised interest rates for an 11th consecutive time in March to 4.25% with a quarter-point rate increase largely expected at the MPC’s meeting in May. Financial markets are also forecasting a 50% chance of an additional rise in August.
Deflation is likely on its way for the UK as prices across the board return to their prices prior to Russia’s invasion of Ukraine. The Office of Budget Responsibility is currently forecasting deflation and a fall in consumer prices in 2024 and 2025 as these prices continue to stabilise and fall from their spring 2022 peaks.
This fall in price is not impacted by government policy as concerns around shortages appear to have been misplaced. Austerity, pay suppression, and interest rate rises are government policies that will over-restrict consumer spending and make deflation harder to achieve.
Interest rate changes
Increases and reductions to interest rates take 12 to 24 months to have a full impact on the economy. The Bank of England has already been too aggressive with its interest rate changes and the economy is still a long way from seeing the impact of the increases that had already been made.
Another Bank rate is potentially on the table for this month’s MPC meeting with a further additional bump likely to be agreed upon at the August meeting. Is this policy overkill when deflation appears to be on its way within the next two years?
Inflation is predicted to fall below zero for eight quarters from the middle of 2024 according to most market forecasts. The OBR forecasts that natural gas prices will half by mid-2025 while accounting for the Bank rate to remain above 4%.
Most economists expect the Bank rate to remain high at 4.5% for most of 2023. Economists have criticised the increasing Bank rate from all sides with one opinion piece in the New Statesman pointing to interest rates as ‘recklessly driving the UK into a deeper recession’.
It suggested in the summer of 2022 that rising the Bank rate would do little to control inflation and instead drastically increase unemployment. While unemployment has remained stable in the UK, there is a significant number of economically inactive people within the working-age population, particularly due to long-term illness. The headline unemployment statistics do not account for this sizeable increase.
The same opinion piece pointed out that for 800 years of data from the Bank of England, 350 years have seen prices fall. Historically, there is a trend of deflation as the most likely outcome from bursts of double-digit inflation, such as what we’re experiencing today.
Even in mid-2022, forecasting was predicting that deflation would likely be on its way to the UK during 2024 as prices begin to fall.
Going alone, instead of following the EU and USA
The Bank of England needs to break the trend of following in the footsteps of the USA and EU when setting monetary policy. The overall level of consumption is likely to decrease in 2023 as consumers find themselves with less disposable income.
Economists are predicting that the global banking system’s recent turbulence could lead to borrowing costs being further increased, resulting in more drag on the economy. There is growing concern that the continued increase of the Bank rate could push up the cost of doing business to a non-maintainable level.
China’s deflation, which began to occur at the end of 2022, will eventually make its way over to the UK. When deflation begins, it’ll require the Bank of England to reassess its interest rates in a new light.
The UK also needs to go alone in its monetary policy-making by viewing the next general election as a potential catalyst if the markets come to believe that government cuts will not be delivered or replaced with an alternative plan.
Britain currently has the highest level of inflation in the G7. It runs twice as high as inflation in the US and significantly higher than comparable EU nations. Inflation in the US has dropped to its lowest in almost two years with economists expecting the Federal Reserve to stop raising interest rates soon.
The Eurozone saw inflation drop to 6.9% in March, suggesting that the UK needs to take its own path forward.
Jeremy Hunt remains committed to the government’s assurance of halving the annual inflation rate this year. The UK’s core inflation, which removes factors that are driving volatility, such as energy and food cost, remains stuck at 6.2%. This core inflation will need to fall for deflation to be encouraged.
The Bank of England’s chief economist expects that inflation will cool down in the second quarter as the pound hits a 10-month high. The pound appears more stable as it pushes higher against the dollar, largely trading at $1.25. They also point to wage rises easing as inflation begins to fall. Private sector regular pay growth sits at 5.5%, its lowest level since December 2021.
The continued fall in fuel prices will likely deliver a fall in inflation in the coming months as energy prices continue to stabilise. Tackling food inflation should be a priority for policymakers as one of the most volatile components continuing to keep overall inflation in double digits.
Where do we go from here?
The headline is that deflation is likely on its way for the UK if the most volatile inflation, particularly food inflation, can be reduced. Economists expect that the UK will manage to avoid a recession this year as inflation begins to cool down and drop into single digits as the cost of living crisis eases with energy and fuel prices reducing to 2022 prices.
The global economy is expected to benefit from China’s removal of its COVID policies as supply chains finally return to their pre-pandemic levels. The Chancellor has said that the UK’s economic outlook seems “brighter than expected”, a view echoed by the EY that suggests a recession is not imminent.
The UK is forecasted to record 0.2% growth for 2023, a significant upgrade from the -0.7% contraction predicted by economists at the beginning of the year.
While the economy is likely to remain flat-lined for the first half of this year, the summer should bring with it the start of deflation, driven by wholesale energy prices subduing. The economy is slowly turning a corner, but policy overkill could make the situation worse.
Adrian Lawrence FCA with over 25 years of experience as a finance leader and a Chartered Accountant, BSc graduate from Queen Mary College, University of London.
I help my clients achieve their growth and success goals by delivering value and results in areas such as Financial Modelling, Finance Raising, M&A, Due Diligence, cash flow management, and reporting. I am passionate about supporting SMEs and entrepreneurs with reliable and professional Chief Financial Officer or Finance Director services.
