Briefing | Action to tackle the cost of living
22 September 2022
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Britain currently faces high inflation, which for many households means a cost-of-living crisis. Why is inflation high? What risks confront us for the future? And what policy tools are available to improve the situation?
Causes of UK inflation
In a mechanical sense, the elevated level of inflation is due to the rising costs of energy and other commodities such as food, as well as rising import prices that relate to the depreciation of the pound. Global supply chain bottlenecks coupled with a swift recovery of global demand following the Covid crisis contributed to price pressures across the world. In addition, the UK also faces new trade barriers following its departure from the EU. Ultimately, all these forces constrain the potential capacity of the economy – make us poorer – and, without adjustment to the demand side, lead to higher prices. Yet, inflation is also broad based and in a deeper sense, the elevated inflation in the UK (and elsewhere) is a symptom of the imbalance between constrained supply on the one hand, and strong demand supported by expansionary stance of fiscal and monetary policies on the other.
Risks that inflation becomes entrenched
While wages have not kept up with inflation, wage inflation has gone up and the risk of a wage-price spiral is real. Inflation has become a salient issue and has started to feed into expectations of future inflation. A strong response of the Bank of England should keep expectations in check; however, speculation that the government may curtail the Bank’s independence or adjust its goals is detrimental to this effort. The continued tight labour market creates circumstances in which currently high inflation is more easily passed on to wages. Plans to carry out more expansionary fiscal policy would further exacerbate the imbalance between demand and supply, propelling rising prices.
Tools for tackling inflation
The UK can achieve the goal of turning the current cost of living crisis into a temporary episode, but only if it acts in the right way.
- Energy is the core driver of current inflation, so the UK should aim to reduce its dependence on fossil fuels which are prone to sudden shifts in price. This means increasing investment in energy-saving technologies and renewables in both the short and long term. The Truss government has also taken steps to mitigate energy price rises for households and businesses. The approach they have taken, however, fails to suppress demand for energy in the same way as a more targeted support policy could have done presenting serious risks.
- Fiscal policy. The current government's policy of attempting to increase economic growth through tax cuts seriously risks embedding inflation, leading to a prolonged period of rising prices. These unfunded tax cuts further risk increasing the deficit, exacerbating the pressures on the sterling, and adding to inflation. Targeted action to improve the circumstances of those most vulnerable to cost-of-living pressures should be preferred to general fiscal expansion. Fiscal policy should be aligned with monetary policy, and not go directly against it.
- Monetary policy. While tightening is certainly required to bring inflation under control, the right speed of this adjustment is difficult to judge. The circumstances – current inflation rate, drifting expectations, and fiscal outlook -- require fast adjustment to the level of interest rates and appropriate monetary stance in general. On the other hand, a more gradual approach would limit the risk of overdoing the tightening in an economy that is likely to suffer zero or negative growth rates for some time. At this point, evaluating these trade-offs is very hard and empirical evidence will need to determine whether a more or less gradualist approach may be beneficial as economic circumstances evolve.
Policy tools are available which could both enable the UK to weather the worst of the storm. They would need, however, a sharply different focus to those likely to be announced on Friday. If the UK government were to act in the right way, this difficult period could be remembered as a time which redistributed the burden, acted as a showcase for social solidarity and provided a catalyst for the UK becoming a stronger, greener and more resilient economy. Making wrong choices now instead risk the economic stability of the UK. If ever, now is the time for an evidence-based approach to policy.