International Finance
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The UK inflation rate surprise

IFM_ UK inflation
Interest rates are a blunt tool to combat inflation, but they remain central banks' main tool

According to Bank of England policymaker Catherine Mann, the UK has a bigger inflation problem than either the US or the eurozone. The latest official UK inflation figures show that inflation in the UK has slowed from double digits to 8.7% over the 12 months to June 2023. But this is still above the 8.2% interest rate forecast by the Bank of England earlier in the year. The UK interest rate is also almost double the corresponding US rate and significantly higher than the eurozone inflation rate of 7% in May, which slowed to 6.1% in June.

All three regions experienced the economic shock of the COVID-19 pandemic. EU countries and the UK have struggled with dramatically rising energy prices due to the Russian war in Ukraine. But two specific problems in the UK are compounding the country’s inflation woes: the negative economic shock of Brexit and the UK’s reliance on the financial services sector. Therefore experts think rate hikes by the Bank of England will not be enough to bring inflation down.

The UK government should also play a role in re-balancing the post-Brexit economy away from financial services and towards other traditional sectors such as manufacturing. Interest rates are a blunt tool to combat inflation, but they remain central banks’ main tool. They affect the economy in various ways. The most obvious is to reduce the demand for goods and services by increasing the cost of various forms of debt (e.g. mortgages). However, interest rates also affect the ability of companies to repay their debt and reduce debt.

In the 1950s the UK had a balanced economy, more evenly split between manufacturing and services. Manufacturing (including gas, electricity and water utilities) accounted for over 40% of total UK economic output, while the service sector accounted for 50%. The UK was responsible for a quarter of world trade in manufacturing. The government of the time prioritized production for export, making the UK a leading shipbuilder and a European centre for the production of cars, coal, steel and textiles for sale to other countries. Science-based industries such as electronics, computers and engineering also thrived in the UK and the country benefited from this third technology revolution.

However, advances in science-based industries have not been rapid enough to offset the decline in employment in manufacturing in the UK from the 1960s onwards. In the 1970s, the government embarked on economic policies centred on a housing boom and financial markets, the focus of the City of London. The British public has been told that their future lies in working with their brains, not their hands.

The deindustrialization policy was initiated by British Prime Minister Margaret Thatcher and continued under Tony Blair and David Cameron. These policies were presented as economic modernization that would improve workers’ wages and society at large. Even the Labor government, traditionally associated with the working class, believed that the future lay in the knowledge economy and set out to transform Britain into a global service provider.

By 2011 around 80% of UK workers were employed in the service sector and only 10% in manufacturing. Various factors explain this decline in manufacturing jobs, including the replacement of routine labour by robots and computerized systems, rising imports from China and other emerging economies, and government policies.

The rise of the City of London, finance, insurance and property industries under Conservative and Labor governments has transformed Britain’s economic trajectory. For example, the city has attracted the best-educated people from other regions and professions into high-paying London jobs. People who might have become scientists or engineers instead became bankers or hedge fund managers. So although the city generates €85 billion a year and employs over 580,000 people, it’s not a goose that lays Britain’s golden eggs, but rather a cuckoo in the nest. It has crowded out other sectors that traditionally provided prosperity to the whole country.

The UK financial sector is now causing another problem: its dominance has made it harder for the Bank of England to control inflation amid concerns that higher interest rates will weigh on banks’ balance sheets. For this reason, monetary policy alone will not be able to contain inflation in the UK. The bank has spoken about the difficulties it faced in forecasting the recent surge and continued inflation. But advances in statistical techniques and computing power have improved the ability to forecast inflation.

On the other hand, according to Edward Thomas Jones, Lecturer in Economics, Director of the Institute of European Finance, Bangor University and Yener Altunbas, Professor of Banking, Bangor University, potentially unanticipated government policies and the structure of the UK economy posed a greater challenge. Banking models had little chance to accommodate the political turmoil and policy changes resulting from Brexit. For example, post-Brexit trade between the UK and the EU has become significantly more difficult, leading to a drop in supply and rising prices. Also, more people from the EU are leaving the UK than arriving, putting downward pressure on wages in certain sectors and exacerbating the inflation problem. Brexit, coupled with the UK’s oversized financial sector, is making it too much harder for the Bank of England to control inflation. The government needs to rebalance the UK economy, with science-based industries playing an important role. This would ensure that the Bank of England can adjust interest rates to fight inflation without having to worry about how that will affect the outsized financial services sector.

Brexit to blame for rising inflation

When the UK voted to leave the EU on June 23, 2016, financial markets were caught off guard and the sterling exchange rate depreciated sharply. Since then, British imports have become more expensive. The column, published in November 2017, found that the weaker sterling boosted consumer prices in the UK by 1.7% in the year after the referendum. Updating the analysis with more recent data, it’s estimated that Brexit depreciation has boosted UK consumer prices by 2.9%. This means an increase in the cost of living for an average UK household of 870 per year, meaning people have to work 1.4 weeks longer to afford the same goods and services.

The Brexit referendum took place over three years ago and the United Kingdom officially withdrew from the European Union on January 31, 2020. While the debate on the economic fallout from Brexit has focused on forecasting long-term impacts, enough time has now passed to examine how the UK economy has been impacted by the Brexit vote. There are two aspects of impairment which are worth highlighting. First, the sudden drop in sterling, which was the sharpest exchange rate depreciation since the collapse of Bretton Woods in any of the world’s four major currencies. Second, despite some short-lived appreciation, sterling’s decline has proved unusually persistent. Currently, the Sterling exchange rate is $1.30 against the US Dollar and $1.20 against the Euro. These values are similar to those after the referendum.

Textbook economics predicts that imported goods and services will become more expensive when the exchange rate depreciates. But the experts examine this mechanism in detail using consumer price data collected by the Office for National Statistics (ONS) to calculate the UK’s official consumer price index (CPI). The main variation they use to find out the impact of the weaker exchange rate is the difference in import risk across 84 product groups.

The aggregate import share is a weighted average using 2016 CPI expenditure weights. The standard deviation is unweighted and calculated across 84 COICOP (classification of individual consumption by purpose) classes. It shows import shares across 12 spending categories in UK consumer spending, accounting for both direct import consumption and indirect consumption of imported inputs used by domestic producers.

Import shares tend to be relatively high in manufacturing, being highest in clothing and footwear. For every pound spent, British consumers spend 49p on imports in this category. In the case of services, the import shares tend to be significantly lower. For example, education only has an import share of 5%, while restaurants and hotels have an import share of 17%. The import share of total UK consumer spending is 29%, with direct and indirect import consumption split roughly equally. Product groups with higher import shares are more exposed to sterling depreciation, which is the reason consumers experience the rise in prices of these products.

Also, experts officially estimate the impact or pass-through of sterling depreciation on UK consumer prices using quarterly data from 2011 to 2018 at the product group level. They found convincing evidence for a high pass-through. The findings stated that if the pound sterling were to depreciate, the price increase for each product group would be the proportion of product imports multiplied by the extent of the devaluation.

The results suggest that the exchange rate pass-through of the Brexit devaluation on the overall CPI corresponds to the overall import share. The Sterling depreciated by around 10%, given that the import share is 29% for the UK. They estimate that Brexit devaluation boosted consumer prices by 2.9% in June 2018. This represents an increase in the cost in the UK.

Experts noted that there is some uncertainty in this estimate, but it is clear that the effect is large. In the absence of evidence of an opposite increase in nominal wages, results suggest that the Brexit devaluation has had a significant negative impact on real wages and average living standards in the UK. Comparing the spending patterns of households in different deciles of the income distribution shows that the costs of devaluation are evenly distributed across all income levels, since there is no systematic relationship between income and the share of imports in household spending.

However, the impact on inflation differs significantly across regions. Households in Northern Ireland and Wales fared the worst as they spend a relatively higher proportion of their income on highly imported products such as food and drink, clothing and fuel. In contrast, households in London were least affected as they had comparatively higher expenses for rent, which has a low import share. Consumer prices rose by 0.7 percentage points more in Northern Ireland than in London.

The decision to leave the EU is the most important change in British economic policy in a generation. There is a broad consensus among economists that the long-term welfare effects of Brexit will be negative, but it will be years before these predictions can be rigorously tested.

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