The consequences of the pandemic for inflation - Capital Economics
UK Economics

The consequences of the pandemic for inflation

UK Economics Weekly
Written by Andrew Wishart

The surprise rise in CPI inflation in July highlights that the effects of the pandemic will not only be deflationary. The hit to supply from the pandemic combined with shifting spending patterns may push up inflation in some areas. Ultimately, though, there is still a large margin of slack in the economy and unemployment will surge when the furlough scheme ends. The resulting hit to the buoyancy of the job market, household incomes and demand will be the predominant driver of inflation over the next two years, keeping it below the 2% target and forcing the Bank of England to expand its QE program further.

The surprise rise in CPI inflation, from +0.6% in June to +1.0% in July, highlights that the effects of the pandemic will not only be deflationary. While some of the increase was due to recovering oil and fuel prices, core inflation also rose. That was partly due to an absence of sales of summer clothes ranges that usually cause prices to drop in July. (See here.)

The sales might merely have been delayed until August. But there is also a broader explanation for the rise in inflation, namely that the hit to supply from the pandemic combined with shifting spending patterns has pushed up inflation in some areas. Indeed, while overall activity is still some way below normal, retail sales have already recovered to 3% above pre-virus levels. (See here.) This shift of demand away from services towards goods may explain why core goods inflation has spiked not just in the UK, but also in the US and the Euro-zone. (See Chart 1.)

Chart 1: Core Goods Inflation (%)

Sources: Refinitiv, Capital Economics

Pockets of inflation are likely where unusually strong demand meets reduced supply. Inflation in furniture prices rose in July and could strengthen further as high housing transactions bolster demand. The substitution of foreign holidays for staycations may push up prices of holiday accommodation in some places. (See here.) And the combination of the Eat Out to Help Out (EOHO) restaurant discount scheme, which saw the number of people eating out up by 70% y/y on Monday (see here), combined with reduced capacity may tempt restaurants to raise their menu prices and keep them higher after the scheme ends.

Meanwhile, the flash PMIs for August indicated that the strong initial rebound has continued, which could limit the drag from the weak economy on inflation. (See here.) Even so, our BICS indicator (see here) suggests activity was 7.5% below pre-crisis levels at the start of August, putting it on a par with the peak-to-trough fall in output in the Financial Crisis and the Great Depression. (See Chart 2.) So there is still a large margin of slack in the economy.

Chart 2: CE BICS Indicator & GDP

Sources: Refinitiv, ONS, Capital Economics

The costly but effective government response has facilitated this first leg of the recovery, but the end of the furlough scheme will cause unemployment to rise. (See here & here.) The resulting hit to the buoyancy of the job market, household incomes and demand will be the most important driver of inflation over the next two years.

Overall inflation will drop back in August as the VAT cut for the hospitality & tourism sectors and the EOHO restaurant discount are taken into account. Beyond that, we are content with our view that inflation will remain below the 2% target this year and next, causing the Bank of England to expand its QE programme much further. (See here.)

The week ahead

We will hear from Bank Governor Andrew Bailey on Friday at his (virtual) Jackson Hole debut on Friday and MPC member Andy Haldane on Wednesday.


Economic Diary & Forecasts

Upcoming Events & Data Releases

Date

Country

Release/Indicator/Event

Time (BST)

Previous*

Consensus*

CE Forecasts*

UK Data Response

Mon 24th

No Significant Data Released

Tue 25th

UK

CBI Distributive Trades Survey (Aug)

(11.00)

+4

+6

Wed 26th

UK

MPC’s Haldane on “International Culture” panel

(17:00)

Thu 27th

UK

Lib Dem Leadership Result

Fri 28th

UK

UK Economic Sentiment Survey (Aug)

(10.00)

75.5

80.0

DR

UK

MPC’s Bailey speaks at Kansas Fed Symposium

(14.05)

Selected future data releases and events

Tue 1st

UK

IHS/Markit CIPS Manufacturing PMI (Aug, Final)

(09.30)

55.3p

DR

UK

M4 Money Supply (Jul)

(09.30)

+1.0%(+13.10%)

DR

UK

House of Commons returns from Summer recess

Thu 3rd

UK

IHS/Markit CIPS Composite PMI (Aug, Final)

(09.30)

60.3p

DR

UK

IHS/Markit CIPS Services PMI (Aug, Final)

(09.30)

60.1p

DR

Fri 4th

UK

IHS/Markit CIPS Construction PMI (Aug)

(09.30)

58.1

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts*

%q/q(%y/y) unless stated

Latest

Q1 2020

Q2 2020

Q3 2020

Q4 2020

2019

2020

2021

2022

GDP

-20.4(-21.7) (Q2)

-2.2(-1.7)

-20.4(-21.7)

+17.0(-8.9)

+3.3(-5.9)

(+1.5)

(-9.5)

(+9.0)

(+3.3)

CPI inflation

(+1.0) (Jul.)

(+1.7)

(+0.6)

(+0.5)

(+0.4)

(+1.8)

(+0.8)

(+1.3)

(+1.4)

ILO unemployment rate (%)

3.9 (June)

3.9

3.9

5.1

6.2

3.8

4.8

6.6

5.4

Bank rate, end period (%)

0.10

0.10

0.10

0.10

0.10

0.75

0.10

0.10

0.10

10 yr gilt, end period (%)

0.22

0.36

0.17

0.20

0.15

0.83

0.15

0.15

0.15

$/£, end period

1.32

1.24

1.25

1.30

1.35

1.33

1.35

1.35

1.35

Euro/£, end period

1.11

1.14

1.11

1.12

1.13

1.18

1.13

1.13

1.13

Sources: Capital Economics, Refinitiv

* Assumes the UK and the EU agree a slim trade in goods deal by the end of the year, with the status quo for services and financial services maintained until a later date. (See here.)


Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com