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Victoria Bao
Introduction
In the past two years, the United Kingdom encountered mishaps more than once. Two significant events, COVID-19 and Brexit, have added much hardship to the livelihood of its citizens. The EU was baffled by the British people as they bid the EU farewell after the 4-years long tug of war (BBC 2021), and the idea of herd immunity was such intelligence that catalysed the dreadful and dire pandemic. The country’s inflation rate fluctuated like a screaming roller coaster at Winter Wonderland. As Christmas 2021 arrived, the inflation rate in the UK reached a 10 year high of 5.2%, far above the target of 2% set by the Bank Of England.
When arguing about whether the problem inflationary pressure will disappear, the answer may not be predicted in the short term, and it is likely to carry on for a surprisingly long period of time. Although some economists suggest that the current inflation is the following disaster for the British economy, because of its negative consequences, given the current global economic circumstances, this essay argues that inflation may not be as alarming as alternative possibilities.
Background The UK Covid-19 has inflicted heavy losses on global economic activity. It brought the UK gross domestic product (GDP) growth rate to a rock bottom of -21.2% in July 2020 (Government of The United Kingdom, 2021). Most international transactions, such as imports and exports, were slashed, wreaking havoc on supply chains. The UK total trade fell by 18% in 2020, which became the lowest value in 5 years (Government of the United Kingdom, 2021).
Aside from the pandemic, Brexit has significantly impacted UK trade volumes, especially with the EU. Between 2019 and 2020, exports from the UK to the EU fell by 14%, while imports fell by 19% (Ward,M. 2021). The sluggish economy caused the UK inflation rate to drop from 2% to 0.2% in July 2020, well below the target. However, by the end of 2021, the entire inflation situation had been dramatically reversed, with the country’s inflation rate rising to 5.2% by December (Government of the United Kingdom, 2021).
What induces “roller coaster” inflation?
Price level reflects the degree of scarcity of goods and services in society. A simple rule applies here: shortage leads price up, but surplus decreases prices. Economists use aggregate demand (AD) and aggregate supply (AS) to determine factors influencing the price level. Causes of inflation can thereby be sorted into two branches of AD and AS. Monetary policy is vital in influencing aggregate demand. In March 2020, the Bank of England announced the interest rate cut before officially reducing it from 0.75% to 0.25%.
A week later, it declined even further to 0.1%, the lowest level in history (Bank of England, 2021). Britain’s high unemployment rate kept rising to a peak of 5.2% in November 2020 and has been above 4.5% for seven months (Office for National Statistics, 2021). At the same time, the inflation rate has decreased from 1.5% to 0.6%. A quantitative easing programme can be realised when interest rate reached a point where was near 0% and can not be lowered fuether. As the quarterly GDP growth rate was -2.6% in the first quarter of 2020, this quantitative easing stimulus program would inject more money into the UK economy, achieving the goal of calming financial markets. For approximately nine months, until December 2021, 1.0% of interest rate was held. The low interest rate might delay the rate of layoffs and boost consumption, causing an excess of aggregate demand. As a result, demand-pull inflation emerged. It is worth mentioning that the UK has cut interest rates twice in a short period of time, which is likely to cause combined effects on the inflation rate under the influence of policy lags. Exacerbating the inflationary pressure and leading to the surprisingly high inflation rate by the end.
The government’s policy caused the aggregate demand to rise further. In April 2021, the UK government set a pay boost of 6.6% increase to the national living wage for those over-23s (BBC, 2021). The wage rise was more than double the change in the cost of living in October 2021. During the same year, a 14.2% rise in consumer spending (Barclays, 2021) appealed as an instant consequence, deepening the impact of demandpull inflation.
Labour shortage was a severe problem Britain was experiencing on the aggregate supply side. Lockdown regulations and Brexit both contributed to it. Three lockdowns were implemented. The most recent one between July and September 2020 had a significant impact on the labour market according to the 0.5% unemployment rate increase in those three months. The peak rate of 5.2% was reached two months after that lockdown due to layoffs. Since younger generations lack professional experience and expertise, they are the most susceptible category of people in the labour force. As a result, they are more likely to work in low-skill positions. Limited occupations are disproportionately impacted by Covid-19 and lockdown rules, leading in a drop in demand for young folks. Besides, european workers were enticed to leave the British labour market due to Brexit. Accordingly, the high unemployment represented a massively shrinking labour market. The shortage of labour causes the wage to be higher, thus increasing production cost. With current price level, the production is declined and could not meet consumers’ demands, thereby occasioning a rise in price levels. Cost-push inflation was generated as an outcome.
The fuel supply crisis further damaged the aggregate supply in the UK. It was not only because of a decline in trade volume but also surprisingly caused by the lack of lorry drivers - the chain reaction of labour shortage. As reported by the Grocer Trade magazine, the Brexit and the change of IR35 tax rules may have caused 12,500 EU drivers to be out of their jobs in the UK (Holems,H. 2021).
Furthermore, vocational driving tests had been shut down because of Covid-19. Naturally, fewer candidate lorry drivers had been unable to pass the Heavy goods vehicle (HGV) tests, resulting in a decline in the number of people completing the test in 2021 by 25000 people compared to the average (BBC, 2021). Due to a shortage of lorry drivers, most petrol stations in the UK ran out of fuel for a few weeks. Energy prices were rising due to decreased supply of fuels. By the end of October, the weekly fuel price had increased by 5.2%, and within one month, the percentage change rapidly grew by 4.4% more (Government of the United Kingdom, 2021). By the end of November, the total increase of 9.6% forced the oil price to be prohibitive. Energy was a key factor of production for companies. Therefore, adjustments in the energy price level led production costs to be grown, and producers have passed on some or all of the additional energy costs to their customers as the necessity had an inelastic price elasticity of demand (PED). Thus, price levels were pushed up, becoming one of the culprits of the unexpected inflation.
Should we take the inflation momentously?
The UK economy had been experiencing difficulties due to the surprisingly high inflation rate by the end of 2021: citizens’ living standards dropped as a byproduct of inflation; income inequality was further aggravated, and menu costs for businesses may well climbed… However, it is pointless to consider the negative consequences of a particular economic phenomenon without comparing it with other possible outcomes. Economists love to consider opportunity costs. Instead of asking how wicked the inflation is, a fair question should be whether the current high inflation is superior to other non-inflationary scenarios.
How about other solutions? The interest rate will not be whittled down by prioritizing to maintain low inflation. No wage increase was launched, leaving people’s consumption retrenched. Unemployment rates will continue to escalate under impacts from both Brexit and the pandemic, with a slash in productivity and a colossal setback to the country’s GDP, pushing the UK into a deeper recession.
What Britain has done was an opposite strategy. They temporarily left the inflation and addressed the labour shortage caused by Brexit with the high unemployment rate caused by the epidemic. The solution was to decrease interest rates and encourage people to make consumption. As the epidemic eased and restrictions to indoor activities were removed, a cut in interest rate caused consumers to make more consumptions and made the economy perk up fairly rapidly. Even the country experienced significant inflation upturn, the overall state of the economy has improved in a short period. Inflation indeed has negative implications for people in the nation and the overall economy. Nevertheless, after weighing the benefits and drawbacks, present inflation does not seem to be the worst outcome.
Would inflation last everlastingly?
(N Gregory Mankiw, 2013)’s 10th principle of economics states that society faces a shortrun trade-off between inflation and unemployment. This idea was illustrated by the hypothesis of (A. W.Phillips, 1958) about an inverse relationship between corresponding rates of rises in wages and unemployment rates and the creation of the Phillips curve by Paul Samuelson.
To analyze the trade-offs between the two rates, I gathered statistics on inflation and unemployment rates in the United Kingdom for 2020 and 2021. Initially, there was no evident link between the two on the surface. However, after plotting them in Figures 1.1 and 1.2, a shift in the two Philips Curves has surprised me since that change links me with the assertion of Robert Emerson Lucas, Jr.
The new classical economist Lucas took a step further on the original Phillips Curve by developing rational expectation theory for predicting future outcomes of current stabilization policies. He stated that rational market participants would use information or resources about past errors to forecast future price changes (Brue, S.L. and Grant, R.R. 2013).
Given the fact that both Covid-19 and Brexit in the UK heavily impacted the UK economy, with lockdown policies, people have to stay at home, ending up with 24 hours of non-stop coverage of Covid, Brexit, governments ’solutions, and the consequent analysis. With reduced information failure, forced rationality by the unpredictable external environment, and enhanced economic knowledge, British people are putting more attention on local economic activities, being an “Econ Person” more than ever. Consequently, it is obvious how expansionary fiscal and monetary policies raised people’s inflation expectations, proved by my observations on a shift in SRPC (Figure 2). More evidence comes from the UK government’s March 2020 announcement of a monetary strategy aimed at lowering interest rates, as well as a wage increase in April 2021 (Figure 3).
Increased inflationary expectations mean people have accepted the steadily rising inflation and will react to this circumstance. Producers adjust the price level to keep up with inflation. Individuals request higher wages in order to maintain their living standards. A salary increase is also a push-up on production costs. Therefore, firms raise the price level further to achieve their desired profit. A positive feedback loop is generated in this situation, which might encourage the rise in the price level to be sustained. Obviously, inflation is not transitory in this circumstance. The growth of the inflation rate goes on and on.
Conclusion
Focusing on the recent UK, if we define the word “matter” to be having negative effects, inflation must matter. Because in whichever scenario, it can invariably cause problems to the government and citizens inside the country. While base on the current situation of Britain, inflation may be the best outcome with negligible loss as the country must make trade-offs to recover the economy from both Covid-19 and Brexit as soon as possible.
Most of the current inflationary pressure is out of control of the UK government or the Bank of England. These pressures therefore can perhaps only be mitigated rather than countered, otherwise extreme measyres maybe extremely damaging to an already structurally weakened UK economy. At the same time, the continuously climbing inflation rate installs people a higher inflationary expectation. Those make controlling inflation a prolonged fight.
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