Sunday, January 02, 2022
The rise and fall of inflation - and other 2022 stories
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission.

At this time of year, it is necessary to look forward, but I also find it useful to look back. In the equivalent column to this one 12 months ago, I gave you my version of the 5:2 diet, five reasons to be cheerful, and two to be a little worried.

The 5:2 diet was, as its name suggests, a weight loss programme once favoured by George Osborne, the last Tory chancellor but two, whose political career ended soon after the EU referendum, and who is now becoming something of a historical figure.

The reasons to be cheerful, despite what was then a grim start to the year, were vaccines, that growth would bounce back strongly with the removal of restrictions, that Donald Trump was no longer around to make a bad world trade situation worse, that the thin trade deal with the EU was better than no deal, and that households had built up a stock of involuntary savings to spend.

The reasons to worry were the virus and its potential variants, and the state of the public finances. On the deficit, hand on heart, I thought the chancellor would wait longer rather than announce, as he did, some humdinger but deferred tax hikes in his early March budget.

I do not have diet analogy to share with you today, though I am quite tempted by the idea of the Paleo, or Paleolithic diet, eating like our caveman ancestors. Mind you, I am not going to be wearing the outfits.

The big picture is not, however, so different to what it was a year ago, though the start of 2021 was quite a bit gloomier than where we are now, and the third lockdown during the winter weeks of January and February was grim.

I will return to this when I do my annual forecasting league table soon but growth forecasts for 2021 were too low – the average was 4.5 per cent, with a high of 6.1 per cent, compared with a likely 7 per cent outturn – because economists were too gloomy about what would happen in the early months of the year. Lockdown 3 was expected to reduce gross domestic product (GDP) by 4 per cent in the first quarter. Had it done so, 2021’s growth would have been much lower. In the event, there was only a 1.3 per cent first quarter fall.

The average new forecast for growth this year, 4.7 per cent, is similar to a year ago, and the same dilemma presents itself. Wil Omicron have only a marginal impact on economic activity in coming weeks, having already led to something of a hit last month, or could it be bigger? On present indications, it looks contained.

Though some sectors are being hammered, in economic terms we are getting better at living with the virus.

We are still worried about the virus and its mutations of course, as we will be for some time, despite encouraging evidence about Omicron. The latest variant, which we can hope but not be sure will be the last, made a fool of those predicting that Covid was on its way out.

We can be a little less worried about the public finances. Though the numbers remain very large by normal standards – the consensus among independent forecasters is that the public borrowing will be £193 billion this fiscal year, 2021-22, and just over £100 billion in 2022-23 – the budget deficit is clearly past its peak. The deficit in 2020-21 was £322 billion, or 15 per cent of gross domestic product, the highest relative to the size of the economy since 1946.

£100 billion is still a big budget deficit by past standards. The Office for Budget Responsibility (OBR) will revisit its forecasts for debt, currently £2.3 trillion or 96 per cent of GDP, and the deficit on March 23. Its recent forecasts have overshot the outturns for government borrowing, though independent forecasters do not expect a repeat of that this year. It is just possible that an improvement in the public finances would allow Rishi Sunak to rein back some of his already announced tax increases, particularly with a cost-of-living crisis underway. But I judge that he would rather keep any spare cash in reserve for eye-catching tax cuts later, were they to be remotely possible.

The big issue in coming months will be inflation. We started last year with an inflation rate of less than 1 per cent and ended it at 5.1 per cent. The extent of the rise took some, including the Bank of England, by surprise. We have nasty months ahead as far as inflation is concerned and, depending on what happens to energy prices in the spring, the next time the cap is lifted, could easily see a rate of 7 per cent. Retail price inflation, regarded as a flawed measure by official statisticians, is already at 7.1 per cent.

After that, while prices might not come down very much, inflation, which measures their rate of change, should do so, a distinction lost on many people. The big increases of recent months will start to drop out of the 12 -month comparison. Whether we get down to just over 3 per cent by the end of the year, the consensus forecast, we shall see. But inflation should come down noticeably in the second half and be lower at year-end than it is now.

Even if inflation is scheduled to rise but then fall, this should be a year when the Bank reimposes an element of normality on interest rates. Markets do not expect that much of a rate hike, expecting 0.75 or 1 per cent for Bank Rate by the end of the year, from 0.25 per cent now. But it would be good if the Bank were to break out of the low range for interest rates which has been in place since the financial crisis, and that the rate was to go up to at least 1 per cent. Since early 2009 the official rate has never been above 0.75 per cent.

The Bank has an opportunity to take advantage of the relatively strong growth in prospect this year, by raising rates. Leave it too long, until the economy settles back into its post-Brexit torpor, and there will always be an excuse not to raise rates.

What about shortages, of workers and supplies? The problem of worker shortages is one that arose because of the interaction of the re-opening of the economy, the furlough scheme and the government’s cackhanded approach to immigration. Labour shortages are not normal in a properly functioning economy, let alone one which has more than 1.4 million people unemployed and nearly 700,000 young people not in employment, education or training (Neet).

The good news is that unemployment is expected to stay roughly where it is, rather than rise. Labour shortages should ease, albeit alongside a squeeze on real wages, though it would be helpful if the government had some kind of employment policy.

There is a risk of continued supply shortages and much of that risk lies in China, where the pandemic started. The ports are clogged, factories are subject to closures and there are doubts about the effectiveness of China’s Sinovac vaccine. Until those supply shortages ease, we will not be able to say the economy has returned to something like normal. Though there are reasons to be cautiously optimistic, the strange times are not yet over.