What causes inflation? Why the UK rate is so high right now and if pay rises really have an impact

Nationwide rail strikes have this week brought much of the UK’s travel plans to a grinding halt, with other sectors seeing unions ballot their members to follow suit in disputes over pay and redundancies as the cost of living bites.

British Airway staff at Heathrow Airport are the latest to confirm union members have voted to strike over the summer in a row over a 10 per cent pay cut imposed on employees during the pandemic.

Royal Mail staff, teachers and NHS staff have suggested they too could stage walkouts after demanding a bump in their wages to help push through the threat of double-digit inflation this autumn.

On Wednesday, UK inflation hit a 40-year high of 9.1 per cent, with the Ukraine invasion and cost-of-living crisis to blame. But the Government has taken a different line.

Simon Clarke, chief secretary to the Treasury, said that “we must be very careful” when it comes to giving pay rises which could spark the return of 70s-style inflation spiral stemming from an oil shock. Between 1967 and 1979 energy crises arose in the Middle East ballooning the price of petrol. It had a knock-on effect on Britain. The Government even considered rationing left-over coupons from the Second World War to help consumers alleviate the pressure.

“Whether or not [the Government’s fear of an inflation spiral] is a valid concern depends on the individual work or sector that is being considered,” Dr Maarten De Ridder, assistant professor of economics at the London School of Economics, told i. “It is very hard to give a general answer.”

What is affecting inflation?

If trade union demands for a pay rise are met, this pressures companies and manufacturers to increase the price of products and services to compensate for higher wages, chasing each other up the ladder into unaffordability, spiralling inflation.

However, the unions point to the fact that the current inflation is caused by energy prices and not wages.

“I think their point is right,” says Michael McMahon, professor of economics at the University of Oxford. “In many sectors the complaint has been that in the last decade they have seen no real wage increases, in fact wages have fallen in terms of what they can buy. But that goes back to the productivity issue. The last decade has been dire for productivity in the UK. Dire by historical standards and compared to other advanced countries over the same period.”

Taking a look back into history, one of the main reasons for higher wages has been productivity.

“If you become more productive you can afford to pay higher wages without putting prices up”, says McMahon. “That’s almost a definition of what we mean by productivity. And so historically we’ve had a lot of occasions where wages have gone up by more than inflation and there hasn’t been this spiral people are currently worrying about.”

Current inflation rates are caused by supply-side factors which are not related to Government policy intervention, such as Russia’s decision to invade Ukraine.

There is also the demand–side inflation in this picture where there is a deluge of people wanting to buy services and products are a given price. “This just means there is more demand for goods than firms are willing to deliver at a certain price which can then further raise the price,” says De Ridder.

“But the inflation we’re seeing is the supply-side of inflation. Firms are no longer able to produce as much as they want to.” Two factors come into play here: rising energy prices and disruption from supply chains due to the COVID pandemic.

Some economists believe the supply factor will be an unlikely catalyst for an inflation spiral via the wage route. And when the source of inflation is supply shock, not demand, the link between wage and inflation seems fairly weak.

What are the concerns?

Despite this, what the Government is afraid of are the types of firms where the wages would rise, leading the cost of services and products in those industries to follow. This would then push the industries to push wages up to compensate for the higher wages.

While employees are demanding a higher wage to pay their bills and food, businesses are also suffering from this crisis. If staff demand more pay, that will then bulk up labour costs. But if you look at it from the other side, the Producer Price Inflation – a measure of how much firms are having to pay for goods needed and used in their production – it’s hitting around 20 per cent.

“Energy is affecting them too,” says McMahon. “We always talk about the cost-of-living crisis but there is also a cost-of-input crisis.”

What is the answer?

What we can take away from a modern approach to monetary policy is learning how to manage inflation expectations. However, the situation right now is tough one for monetary policy to deal with.

Central banks can affect inflation by affecting demand. In order to do this, interest rates have to go up but then we run into a problem. Although it does drive inflation downwards, on the other hand it also drives down production.

Businesses are already impacted by the cost-of-input crisis therefore production will fall but inflation rises – a supply shock.

“Dealing with supply-shock with demand shock tools is really tricky because you have to choose: do we want to get inflation under control but have even worse recession, or do we want to ignore the recessionary part and let inflation go higher but then the risk is that inflation becomes ingrained in the national psyche. This means the more people expect inflation the more we get inflation.”

“This is the challenge.”