Halfway up the inflation mountain

The leap in inflation from 2.0% in June to 3.2% in August was the largest ever monthly rise in inflation and is only the start of a trend that should take inflation to beyond 4.0% in early 2022. This surge will be mainly driven by increases in energy, fuel and food prices, rather than services inflation. It means that the way back down the inflation mountain should be just as quick as the run up it, and that the Monetary Policy Committee (MPC) should look through this temporary period of higher inflation. 

Inflation’s rise was driven by those sectors which have been most affected by the pandemic. In the restaurant and hotel sectors, inflation jumped from 2.2% in July to 8.6% in August. This was mainly a base effect, because prices in restaurants were depressed in August 2020 by the Eat Out to Help Out scheme and the VAT cut across the hospitality sector. Restaurant and hotel prices fell by 4.7% m/m in August last year, but rose by 0.2% this August. Another major driver was higher airline inflation, which leapt from 2.2% in July to 14.4% in August as the travel sector began to reopen. 

There were also signs that continued shortages of goods and materials were still driving up costs. Second-hand car inflation rose from 14.4% in July to 18.3% in August as shortages of new cars increased demand for used ones. Having just bought a used car, this economist can personally testify to the frothiness of the market! 

The recent rise in oil prices also continued to make itself felt as fuel price inflation remained at 17.7%. The rise in food price inflation from -0.5% in July to 0.2% in August probably represents the pass-through of higher shipping and transport costs. So it’s not surprising that producer input prices rose again from 10.4% in July to 11.0% in August. And there was more evidence that manufacturers were passing these costs on, as factory gate price inflation rose from 5.1% to 5.9%.

A shortage of natural gas and wind power supply (the latter thanks to a lack of wind in the North Sea) has created a spike in electricity prices, and a lack of container ships has bumped up shipping costs. We already know that these price increases are going to push inflation above the MPC’s most recent forecast of 4.0% by early 2022. It could reach as high as 4.5% by November. But there is not much the MPC or tighter monetary policy can do to increase the number of cargo ships or to make the wind blow, so it should look through this further rise in inflation.

Admittedly, recent comments from the MPC suggest that it has become slightly more hawkish and neither yesterday’s labour market data nor today’s inflation print will have done much to ease the concerns of the more hawkish committee members. However, inflation will fall back just as quickly as it rose as many of the one-off hits from the pandemic and surging commodity prices unwind. We think inflation will be back below the MPC’s 2.0% target by the end of 2022.

Services inflation is the key number the MPC will be watching for any signs that wage growth is feeding into higher prices. Inflation in the services sectors, which were relatively unaffected by the pandemic, so far remains relatively subdued.

We think there will be enough slack in the labour market to avoid widespread jumps in wage growth. This should ensure that inflation drops sharply next year, allowing the MPC to wait until the second half of 2022 before tightening monetary policy.