Inflation afflictions

Published on Public Finances and the Economy

The story of the last 12 months is that inflation has risen rapidly and eroded people’s living standards. From 0.8 per cent in June 2016 inflation is now 2.6 per cent. Despite the small welcome fall last month current projections suggest it will remain around this level for the rest of the year.

The rise has been driven by two intertwined forces. The first is a higher oil price, which went up from around $40 a barrel in the first quarter of 2016 to around $60 by the end of the year (although it has fallen back since). The second is the fall in the value of sterling, which is currently 12 per cent below its level before the vote to leave the EU.

While both have increased inflation they have done so in ways that have affected poorer and richer households differently.

Although there is a single headline rate of inflation, in reality the inflation experienced by a household depends on what they spend their money on and how the prices of the things they buy change. As the chart below shows 18 per cent of total weekly spending among the poorest fifth of households goes on food and non-alcoholic drinks – twice the share spent by the richest fifth of households (9 per cent). Lower income households also spend proportionally more on housing, utilities, and alcoholic beverages and tobacco.

By contrast richer households spend more on transport, the costs of which are heavily influenced by the price of oil. Around a fifth (19 per cent) of their weekly spend goes on transport, compared to just 11 per cent for the poorest fifth of households. Richer households also spend proportionally more on recreation and culture.

Turning back to our drivers of inflation over the last year, rising oil prices in the second half of 2016 (compounded by the fall in the value of sterling because oil is priced in dollars) pushed up transport costs. Over that period, CPIH inflation rose from 0.8 to 1.7 per cent, with transport costs accounting for half of the rise. As a result, inflation for the richest fifth of households was 1.4 per cent compared to 1.1 per cent for the poorest fifth.

In the past six months however, transport costs have been rising less rapidly than housing, alcohol and tobacco, clothing, and food and drink. The second main driver of inflation – the devaluation of sterling – has taken centre stage. The main effect has been to push up the costs of imports. Initially this was felt in input prices (those paid by firms) and, at least at first, firms were wary of passing this onto consumers. However over time the effects of higher import costs – much of the food, drink and clothing we buy is imported – has been felt by consumers.

As a result the cost of these items have been rising: food and drink now accounts for 8 per cent of the rise in CPIH, having previously lowered inflation, while alcoholic drinks & tobacco are both driving up inflation.

The flipside of this is that transport costs are now contributing less to rising CPIH – accounting for 17 per cent for the rise in June, down from 34 per cent in January.

Lower income households spend proportionately more on housing, food and drinks and have therefore experienced higher inflation since the turn of the year. The poorest 10 per cent of households experienced inflation of 2 per cent, by contrast the richest 10 per cent of households experienced inflation of 1.8 per cent.

Looking ahead, its concerning that even if inflation abates (the most recent summary of independent forecasts from the Treasury suggests that inflation will fall back to 2.5 per cent in 2018) there is evidence that it may not provide as much benefit for poorer households. Between the middle of 2013 and mid-2014 inflation fell from 2.9 to 1.9 per cent. However over that period the poorest fifth of households only saw their inflation rate fall from 3.1 to 2.3 per cent.

This could mean that the current squeeze on living standards is longer and deeper than previously expected for lower income households. Although wages may respond to and rise above inflation, benefits are frozen in cash terms and so cannot. Given the importance of state support for many families, alleviating the impact of rising prices by unfreezing benefits should be a priority for the government. If action is not taken then inflation – which has exerted a big drag on living standards since it began to rise a year ago – will likely remain a drag in the year to come.