Higher than expected inflation spike poses more of a challenge to household incomes than to the Bank of England

Inflation is on course to rise above four per cent in the coming months – reducing real average household incomes by £700. And while monetary policy makers at the Bank of England should ‘look through’ this temporary inflation spike, fiscal policy makers should act to protect family incomes and strengthen the recovery, according to new Resolution Foundation research published today (Sunday).

The Foundation’s latest Macroeconomic Policy Outlook explores building inflationary pressures in the UK, how they compare to the pressures in the US that are already sparking fierce debates, and how policy makers should respond to the prospect of above-target inflation.

The Outlook notes that US Consumer Price Index (CPI) inflation has risen from 0.1 per cent last May to 5 per cent a year later – the fastest rise in nearly half a century, while the UK has experienced the fastest six-month rise in inflation since the aftermath of the financial crisis.

And with UK inflation tending to mirror US trends in recent decades, the Outlook notes that fears of an inflationary spiral are also migrating across the Atlantic. The Bank’s Chief Economist Andy Haldane has talked of a ‘dangerous moment’ when the ‘beast of inflation is stalking the land again’.

However, the report demonstrates that the near-term inflationary pressures in the UK are less stark than the US. Looking ahead, the UK’s bigger economic hit during the crisis means that it has more spare capacity to absorb before we start to see sustained price pressures. And whereas the US is currently embarking on a major fiscal stimulus, the UK is about to start withdrawing support, including the ending of business rates relief and phasing out of the furlough scheme.

The Foundation’s analysis shows that while the UK is unlikely to experience the same inflation peaks seen in the US, if commodity prices remain at their current levels, UK CPI inflation could rise above four per cent later this year. This would be more than double the rate of inflation forecast by the Bank of England for the third quarter.

The Foundation says that such a scenario would be the equivalent of reducing average, annual real disposable household incomes by £700 by the start of next year, relative to the OBR’s current economic forecasts for prices and incomes.

The Macroeconomic Policy Outlook notes that the temporary nature of the current inflation spike means that monetary policy makers at the Bank of England are right to be ‘looking through’ it by avoiding premature interest rate increases.

However, these inflationary pressures present a challenge to fiscal policy makers in the UK. The Foundation warns that the Government’s current plan to reduce Universal Credit by £20 a week in October risks being particularly damaging for the six million families affected by the cut, at a time when higher than expectation inflation will, at least temporarily, be pushing down on household incomes.

It urges the Government to reconsider its plans to cut support in order to strengthen the current economic recovery, which risks being undermined by squeezed household incomes.

James Smith, Research Director at the Resolution Foundation, said:

“With the US experiencing the fastest rise in inflation in nearly half a century, and the UK also experiencing sharp increases, many people are getting increasingly worried about a possible price spiral.

“While UK inflationary pressures are nothing like as stark as the US, we could still see inflation breaching 4 per cent this summer – a figure well in excess of the OBR and Bank’s expectations.

“The temporary nature of this inflation spike means the Bank can look through it and avoid premature rate rises. But the £700 hit to living standards it will bring means households and the Government cannot afford to ignore it.

“The Chancellor can start by cancelling the planned cut to Universal Credit this Autumn, which will only add to families’ financial pressures. A squeeze on household incomes later this year, even if temporary, is a significant threat to the strength of our current recovery.”