NIESR blames Bank of England for inflation crisis

While the country continues to count the social cost of the Pandemic, the financial fallout is just beginning.

The National Institute of Economic and Social Research, the longest established research institute in the United Kingdom, predicts that inflation will reach a peak of 7% in April and go on to average 5.9% throughout 2022, and falling to 3.3% next year.

There are expected to be three more interest rate hikes his year with more to follow in 2023. The risk is skewed heavily towards the possible need for more hikes should inflation prove to be stubborn.

The institute criticized the Bank of England’s policy of remaining reactive to inflation rather than getting ahead of the curve.

It is easier to look back to see mistakes that have been made. In real time, making decisions about the direction and ferocity of the rise in inflation coupled with providing sufficient support to ensure that any nascent recovery is not choked off is more difficult.

With conditions already driving inflation higher, the Bank still faces the prospect of inflation busting wage demands this year.

It is a considerable time since inflation was any kind of consideration in pay negotiations.

Real wages are falling rapidly and with the hit to living standards from rising energy bills and higher personal taxes still to come, the prospect for this year will become more testing before they improve.

Andrew Bailey’s request that pay rises are limited will undoubtedly be ignored. While the blame for inflation getting out of control lies firmly with Bailey and his colleagues within the Monetary Policy Committee, there is little to commend the NIESR which was firmly favouring growth over inflation through 2021.

The long-term fate of the currency remains undecided. While rises in both inflation and interest rates will be significant factors, the fate of the services sector remains something of a mystery.

The pound is likely to remain reactive this week. Yesterday, it rose marginally in quiet trading. It reached a high of 1.3564, closing at 1.3550

Next week, data for employment and inflation are due to be released. While it is too early to see any effect on inflation from the recent rate increases, the recent improvements in employment may begin to slow.

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Pandemic Economy mostly to blame

The level of the United States trade deficit reached record levels in 2021. It rose by 27% as imports continued to outstrip exports.

The makeup of the U.S. economy has changed radically over the past two decades, as manufacturing output was exported to countries with a far lower cost base than the U.S.

This has led to the U.S. becoming technology based and concentrating exports on the services sector and big-ticket items like planes and ships.

Reliance on Chinese factories has been of concern to both Presidents Trump and Biden but attempts to reverse this have been unsuccessful as political agendas have become driven by factors that are short term.

Presidential terms have become a year of promises, a year of preparation of midterms, a year of reflection, then a year of campaigning. Sprinkled through the entire term will be a few initiatives that will often be reactive to the prevailing economic and social conditions prevailing at the time.

One area of the economy that reduces the deficit in trade in goods is the surplus the country sees in services. In 2021, that surplus fell by close to 6%.

As the Fed begins to normalize monetary policy as expectations that the Pandemic is going to be less of a factor, expectations are growing as to what the new normal will look like.

There is expected to be a radical change in working from home that will influence services output, although just how that change will materialize remains to be seen. The motor industry has been significantly affected by the shortage in production of microchips, produced primarily in China and Korea.

While the Fed remains committed to the reduction of inflation and being less committed to support for the economy, the social changes wrought by the pandemic remain to be seen.

Inflation data will be released tomorrow. This is expected to be a major factor in the size of the FOMC’s first hike of the new cycle. The Central bank will now need to switch from reactive to proactive and take greater notice of leading indicators to try to disseminate the future path of inflation.

Yesterday, the dollar index drifted higher in quiet trading. It reached 95.74 but fell back to close at 95.61, twenty pips higher on the day.

Energy Mix and differing gas prices driving inflation

Inflation has been casting a shadow over the entire Eurozone for more than six months as the Central Bank tries to prop up the economy by pumping unprecedented support by becoming almost the sole buyer of Government debt issued by some weaker nations.

Inflation has barely been an issue for the region over the first twenty plus years of its life. Therefore, there has been little understanding of what the nuances are of each individual state that make up its inflation profile.

Now that inflation has become an issue right across the region, the differences in the levels of inflation that are being seen have become stark.

The current rate of inflation for the Eurozone is currently close to five percent, or maybe now a little higher.

That is the rate that the ECB bases its monetary policy upon, but, that rate doesn’t apply to a single country of the Eurozone. The actual rate that applied to individual nations varies currently from 3.3% in France to a massive 12.2% in Lithuania. The fact that Lithuania’s economy is a faction of the size of the French economy is not considered.

This brings us back to a question that dominates discussion of monetary and fiscal union, one size does not fit all.

It is clear from country-by-country data that, overall, inflation is above target. However, that range of rates has several factors in its makeup. One of the more dominant is the cost and makeup of energy consumption.

The rising wholesale cost of imported gas feeds through into economies in different ways and at a different pace. The mix of energy use is different country to country, while mitigation of the consumer cost also varies.

The efforts made by the Central bank to mitigate inflation cannot consider rising energy prices or other global factors linked to the Pandemic. Monetary policy is by its very nature a short-term fix and is more effective on the demand side of the economy, while the supply side is where the current issues are rooted.

That means that wage increases can easily overshoot, and demands will be based on often out of date information. For example, wage demands in the Eurozone will be based upon last year’s rising level of inflation but by the time they are negotiated, agreed and implemented inflation may be returning to its target level and will be again driven higher by higher wages down the road.

While it was generally agreed that Central Banks acting reactively was the best policy throughout the Pandemic, a return to a more proactive set of policies should now be a priority.

While the marginally more hawkish outlook for monetary policy mentioned by Christine Lagarde last week provided some short-term support for the euro, that rally is beginning to run out of steam.

Yesterday, it fell to a low of 1.1396 and closed at 1.1418. The first line of support will be around 1.1380, but a retracement of the rise seen following the ECB meeting will be needed to confirm the return of the downtrend.