Risk & Economy » Inflation nation: Out of the frying pan and into the fire?

Inflation nation: Out of the frying pan and into the fire?

With UK inflation outstripping that of most other major economies, Ana Boata, head of macroeconomic and sector research at leading trade credit insurer Euler Hermes, explores the potential for a wage-price spiral later this year.

This month sees the UK mark the second anniversary of the first Covid-19 lockdown. The interim period has been one of immense challenge for finance teams but one that has been met head on – indeed, with many businesses thriving as consumer trends have evolved.

Now, as we begin to move from pandemic to endemic, attention is turning to UK plc’s ability to trade out of Covid-19, with economic growth having been resurgent up until recently – albeit with the economy starting from a lower base point than its international peers, including in Europe, having experienced a greater financial shock.

Hopes for an easy exit are likely to be short-lived, though, as the conflict in Ukraine and a heady mix of pressures – including energy costs, wages and input prices – evident before the war continue to drive inflation. A third base rate increase in three months from the Bank of England (BoE) has given weight to concerns that the economy could be heading out of the frying pan and into the fire.

The BoE has faced a difficult choice in recent months: overlook the inflation rate to protect the economy’s post-pandemic recovery or tighten quickly to stave off a potential wage-price spiral that would push inflation even higher.

A wage-price loop is composed of two phases: the initial price shock being transmitted to wages, followed by a potential feedback effect from wages to inflation as firms adjust their prices to compensate for rising wages and costs.

While we had expected inflationary pressures to recede in the second half of 2022, Russia’s involvement in Ukraine will hit the recovery in terms of confidence, trade and energy costs. For example, we expect GDP growth to be limited to 3.2 percent this year, with businesses halting investment at a similar rate to that seen in 2020 at the height of the pandemic.

These shocks, which effect both business and living standards, have seen us revise our average wage growth forecasts from 3.5 percent to four percent as the unemployment rate continues to decline – closing out gaps in the market – and labour shortages are exacerbated by Brexit. With Q1 being a period when wage rises come into effect for many businesses, it is an issue finance teams will need to be mindful of throughout 2022 – particularly in markets where margins are slim.

Should we fail to see these inflationary pressures recede – most likely driven by a prolonged increase in energy prices and supply bottlenecks – UK firms will need to consider the impact on their wage and pricing structure. In comparison to other countries, including trading partners in continental Europe, general price rises here are reflected much quicker in wage increases – in line with employment market flexibility – allowing limited time for inflationary shocks in the economy to defuse.

The reciprocal trend is for UK businesses to simultaneously increase prices to fund wage rises, creating something of a vicious circle. The key question is therefore to what extent will UK firms be able to absorb potential cost increases while inflation remains high? The answer will lie in the nature of the price shock (temporary like material shortages or persistent like energy costs), the degree of competition and their financial health, such as whether they have the cash to withstand shocks.

In a post-pandemic, post-Brexit era, these inflationary pressures are among the last thing firms would be wishing to contend with. However, the more positive outlook is that policy actions are being taken to prevent any significant spiral materialising. Indeed, we expect the base rate from the BoE this year to reach one percent, with other central banks, like the US Federal Reserve, becoming more hawkish and the European Central Bank better placed to tolerate some overshoot in inflation for the time being.

Our forecasts suggest UK inflation will average out at 7.5 percent this year. However, the risk of a wage-price loop would boost it by a further percentage point in 2022 and see it remain above four percent for another year and a half at the very least. To continue to trade with confidence, finance teams should be factoring this sustained period of inflation into their plans and adjusting their approach to wages and pricing accordingly to avoid jumping from frying pan to fire.

 

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