What are the causes and implications of the Cost-of-Living Crisis in the UK?

By Supeakcha Maskey, Curtis Wu and Sherry She.

Introduction

This article discusses the current cost of living crisis facing the UK and the rest of the world. While the rich are less impacted by such economic change, the relatively poorer population could face a huge living challenge to afford their living bills. The research aims to investigate how inflation impacts the financial burden on each income group while predicting trends of inflation in the short and medium term.

It is a very relevant topic of discussion as it is currently taking place, and it affects almost everybody living in the UK. Not only is this topic interesting to unpack, but it is also likely to captivate many readers. As students who live out/rent, the rising energy prices are a serious concern. Researching and presenting questions such as why the UK has a cost-of-living crisis, what is causing it and questioning what we can do about it are all very engaging and thought-provoking.

Factors causing inflation:

The following paragraphs examine potential factors that contributed to the current crisis.

Today’s two leading causes of high inflation are the rising commodity price and highly volatile energy prices. However, the causal relationship among commodity price, energy cost, and inflation are unclear. Different people propose different perspectives explaining the potential cause of inflation. One side argues that the rising commodity price heightens the production cost and hence causes inflation because the economy faces higher production costs (Igan et. al, 2022). If this is the case, then commodity price is the root cause of inflation. Another side supports the view that commodity price does not cause prices to rise directly (Calhoun, 2021). Instead, the rising price of petroleum and other energy sources forced businesses to face a higher energy cost collectively. As a result, commodity prices rise accordingly. In this case, energy costs are the leading cause of inflation, but the change in commodity prices further exemplifies it.

The role of commodity prices in causing inflation is context-specific, and sometimes it is because of the rise in both energy and commodity prices that are causing inflation. The cost-of-living crisis is a case like this. The COVID-19 pandemic halted worldwide logistics as cities and countries implemented lockdowns. The associated aftermath of this policy is the limited global supply of critical raw materials due to shipping constraints. As a result, the supply of raw materials rose significantly, forcing businesses to bear a higher production cost. Even worse, businesses recognise that future supply is uncertain and are motivated to pile up inventory. The sudden increase in demand to store inventory and limited supply in worldwide logistics contributed to rising prices and inflation. While some infer that the supply-chain disruptions due to shipping constraints are the main cause of cost-push inflation, the war between Ukraine and Russia makes this statement less certain. The rising tensions between Ukraine and Russia pose considerable risks to the energy supply. Knowing that Russia is the second largest natural gas producer and the largest natural gas exporter, the war undoubtedly affected the energy supply worldwide. Russia’s decision to halt natural gas supply to Europe contributed to the energy shortages in the European continent, causing sudden increased demand for other substitutes such as oil and fossil fuels. As a result, energy prices have remained volatile, significantly impacting businesses in Europe and worldwide. The increasing production costs force businesses to set higher prices, creating another invisible force pulling up inflation. It is difficult to conclude whether supply-chain shocks (price level rising due to limiting constraints on the supply side) or energy crises (price level increasing due to higher energy costs) contributed more to the cost-of-living crisis. However, they somewhat influence the decreasing purchasing power (Reis, 2022).

Researchers expressed similar views that supply-chain disruptions are potential causes of high inflation and cost-of-living crisis. Nersisyan and Wray (2022) stated that supply chain shocks have been narrowing down business profit margins and potentially exacerbating inflation. When businesses face a lower margin, they raise product prices and lower expenditures to keep businesses profitable. As a result, inflation becomes apparent when every business adjusts its sales price after facing a lower margin. Reis (2022) further illustrates the role of expectations on rising inflation. As the macroeconomic environment becomes increasingly volatile and inflation rises sharply, the public starts to have a strong belief that inflation will keep rising in the near future. As the public observes the increasing living costs, people are motivated to buy more necessities when they anticipate that prices will be even higher. The sharp rise in prices and increasing demand will cause the price level to rise even higher than before. As a result, an expectation of higher prices drives inflation, driving the negative impacts of the cost-of-living crisis even further.

Historically, the correlation between commodity prices and inflation is commonly observed. The report by Zaremba et al., (2019) investigated the relationship between the two in the UK from 1265 to 2017. The authors observed a strong co-movement between commodity and inflation, especially between the 13th century to the 19th century. A rise in commodity prices is correlated with higher inflation. From the 19th century onwards, the correlation became relatively weaker, but evidence still suggests a direct relationship between the two. One reason for the weakening relationship between commodity prices and inflation is the changing economics nowadays (Zaremba, 2019). Compared to centuries ago, major economies today shifted from agricultural and industrial to service-based economies. As a result, today’s transformed economies are relatively less exposed to the change in commodity prices than centuries ago. Nevertheless, commodity prices today still play a critical role in our economy. As seen in the cost-of-living crisis in the UK, the fluctuating energy costs are still significantly impacting the price levels and purchasing power. This holds for other European countries experiencing energy shortages as well.

Multiple factors contributed to the high inflation and cost-of-living crisis in the UK. The two prominent factors are the supply-chain shock after the COVID-19 pandemic and the energy costs affected by the war between Ukraine and Russia. The disruption in supply-chain narrowed the profit margin for businesses while formulating widespread expectations of rising interest rates. The uncertain energy supply further creates upward pressure on price levels (Reis, 2022), confirming the strong correlation between commodity prices and inflation in the UK observed since the 13th century.

Inflation Prediction Model

After exploring the causes of the current inflation in the UK, we will focus on predicting the trajectory of inflation. Income inequality has traditionally been a contemporaneous by-product of inflation (Berisha, Dubey, Gharehgozli, 2022). Hence, it is imminent to dig into the nature of the current 2022 inflation and predict its trajectory in the short-medium term to assess its full effect on the different income groups.

Amongst the popular inflation prediction models, a naive specification initiated by Atkeson and Ohanian (2001) is the most widely used. It forecasts one-year-ahead CPI by simply taking the past four-quarter growth rate in the CPI. However, Cornea-Madeira and Madeira (2021) showed that the Phillips Curve model with endogenous switching in forecast rules performs better out-of-sample forecasting than the random walk model of Atkeson and Ohanian (2001). The Phillips Curve measures the correlation between inflation and the level of economic output. It is based on the notion that if the current output level is below a baseline rate, then inflation tends to rise over time, and hence we could determine the trajectory of inflation by looking at the output gap.

The Model

First, let us start with a traditional Phillips curve (TPC):

The equation relates the current inflation to lagged inflation and the output gap, meaning that inflation data from previous quarters coupled with the current economic activity is the primary determinant of current inflation. However, one shortfall of this model is that it lacks focus on forward-looking factors like expected inflation that would affect the current inflation rate. (Cornea-Madeira, 2019) further refined the model by incorporating both backward and forward-looking behaviour in the new “Behavioural” new Keynesian Phillips curve (BNKPC):

The model forecasts inflation by putting weights on backwards-looking and forward-looking behaviour to vary endogenously over time and relating it with the output gap, a measure of economic activity.

The Giacomimi and Rossi fluctuation test results show that the BNKPC model forecasts better than the TPC model, especially after 2010. If the curve is within the band, then both BNKPC and TPC models have equal forecasting performance; we can see that for the period before 2010, the two models perform somewhat equally. If the curve is above the upper limit of the 95% confidence interval, then the BNKPC model performs better than the TPC model.

The BNKPC model is also well suited to predicting the current UK inflation as, according to Cornea-Madeira and Madeira (2021), the UK’s backward and forward-looking behaviour has about equal weight. This signifies the importance of incorporating behaviours across time horizons. The paper also estimates the Phillips curve models with UK inflation data from Q1 1966 to Q4 2016 to conclude that there is indeed the presence of a short-run trade-off between inflation and the level of economic output. This further lends credibility to using the model to predict UK inflation.

Inflation Prediction

In the short term (1–3 months), the forecasted naive rule is near optimal if inflation is close to a unit root process (Stock and Watson, 2007). Hence, we project the subsequent quarter inflation for the UK to be close to the current level of 9.9–11.1% (ONS, 2022).

As for the medium term (3–12 months), we have established that the BNKPC model best predicts the current UK inflation. Hence, we can project medium-term inflation in the UK by exploring the variables in the model.

First, we will explore the backwards-looking variable of inflation in period t minus one using the naïve rule illustrated above. The MoM inflation rate from October 2021 ranges from 4.2%-11.1% (ONS, 2022). According to the latest November Bank of England Monetary Policy Report, the forward-looking variable (inflation in period t plus one) is expected to reach 5.2% in Q4 2023. According to Cornea-Madeira and Madeira (2021), on average, backwards-looking and forward-looking inflation expectations have about equal weight in the UK. Hence we could assume theta to be 0.5. Moreover, we need to incorporate the value of the output gap (y_t) into the model. The output gap is the difference between the potential output and actual output as measured by the potential growth rate minus actual GDP in a country. If the value of the output gap is negative, that signifies an “excess supply” in the economy whereby resources were not fully utilised. Historically, negative output gaps have been associated with gradual falls in the inflation rate due to increases in the number of people out of work and, thus, the eventual fall in production level (ONS, 2022). According to the latest Economic and Fiscal Outlook published by the OBR, the forecasted UK output gap for Q4 2023 is -3.1%. This implies that there will eventually be a dip in the inflation rate and a rise in unemployment to come in the near future for the UK. Lastly, to project the inflation rate for the UK, we need to find the value for gamma and beta, which measures the extent to which the inflation expectations and output gap influence the projected inflation for the UK. According to Cornea-Madeira and Madeira (2021), the value of beta is close to 1, and gamma is 0.39 after regressing the UK inflation data from 1966–2016. If we take the abovementioned values, we estimate the medium-term inflation in the UK to be 3.49%-6.94% in the coming 12 months.

Another note is that we expect a significant drop in inflation data after Q1 2023 due to the base effect. Inflation is calculated on a year-on-year basis. When the inflation rate in the previous corresponding year was low, even a slight increase in inflation in the current period will be exaggerated, hence why we are experiencing an unprecedented double-digit inflation rate. As the war between Russia and Ukraine erupted in February 2022, inflation soared by 200 basis points from 7% in March 2022 to 9% in April 2022 (ONS, 2022). Once we have past this period, we will see the inflation rate tone down.

Income Inequality

Inflation is not always bad as it is, at times, a reflection of good things happening in the economy: high demand and high consumption levels. This is called demand-pull inflation. However, as discussed above, the kind of inflation we are experiencing now: the cost-of-living crisis, is argued to be due to cost-push inflation due to disruptions in the supply chain, labour market and a rise in oil prices (Nersisyan and Wray, 2022). This means that prices are increasing not due to high levels of demand but because of high costs related to production costs, such as energy prices. These are a big part of raw materials, production, and transport] processes, and these harm economic activity and the well-being of the economy in general. But are these effects constant amongst all economic agents?

Various research on this topic supports the idea that inflation has different effects on different groups of people: particularly different income groups. Inflation and inequality have a strong positive relation (Beetsma & Van Der Ploeg, 1996). In a 2012 paper, the authors analysed the relationship between income inequality and inflation in 13 European countries from 2000 to 2009. They established a positive relationship between income inequality and inflation for the analysed countries (Thalassinos et al., 2012). This, in turn, influences the economy and the effectiveness of government policies.

Inflation itself is problematic if incomes and wages adjust accordingly. This means that as things get more expensive (this should include wages- the price of labour), your income also increases to match that. However, wages tend to increase at a slower rate than inflation. This is called wage rigidity (Lorenz et al., 2007). Wages take a lot longer to adjust to the price increase; thus, there is a lower increase in real income. The main difference between nominal and real income is the inflation rate. Real income shows us what our income is worth, given the rise in price levels. Calculated as follows:

As inflation rates rise and real incomes fall, households’ finances shrink, and they might need to rethink their consumption choices. However, not all households have the same level of liberty.

Households with different incomes consume differently. This is supported by Jaravel in his paper, noting that these differences create the potential for inflation inequality (Jaravel, 2021). The Office for National Statistics (ONS) explores this further in the 2021 census. They use the Household Costs Indices (HCIs) to analyse the relationship between household inflation and income inequality in the UK.

As the prices of things get more expensive, households with higher income levels can switch to buying relatively cheaper goods and thus mitigate the effect of the rising prices. Low-income households, on the other hand, may not be able to do this. “Research shows that individual spending behaviour is heterogeneous across households and depends on characteristics such as income and wealth.” (Kopiec, 2019).

The HCI measures how much the nominal disposable income of different household groups would need to change in response to changing costs to enable households to purchase the same quantity of goods and services of the same quality. This is different to the Consumer Price Index (CPI), a common measure of inflation. Consumer Price Index (CPI) takes a top-down approach to inflation, while HCI takes a bottom-up approach. Thus, the HCI effectively describes the experience of households (or a group of households) because of changing prices in the UK by measuring the impact of changing prices on the household budget. (ONS, 2021)

Therefore, using HCI ensures that the analysis is more representative of the household experience when prices change reflects their effect on income inequality.

Jaravel (2019) explores this idea further.

It measures inflation inequality using a linked data set covering the full consumption basket of US households from 2004 to 2015, where spending shares are measured using the Consumer Expenditure Survey (CEX).

In the diagram above, inflation declines linearly across income deciles. Here, low-income households are those within the second-income decile, and high-income households are those within the ninth-income decile. Törnqvist inflation (price index, another measure of inflation) was 1.86% for the fifth income quintile and 2.20% for the first income quintile. The average annual inflation difference between the top and bottom income quintiles is 0.346 percentage points, which remains similar to other price indices.

These differences in the effect of inflation and real income have a serious macroeconomic impact. Jaravel (2019) notes that the heterogeneity in consumption baskets matters for stabilisation policy, particularly monetary policy. Due to this, the effectiveness of monetary policy is reduced in general equilibrium (Jaravel, 2021). Additionally, inflation affecting low-income groups worsens the per capita average for the country as well (Beetsma and Van Der Ploeg, 1996). This highlights the importance of considering these aspects of consumer behaviour and patterns when implementing policies since they affect the effectiveness of the policies.

Conclusion

In this paper, we explored various reasons leading up to the unprecedented inflation in the UK in 2022. We found that the nature of the inflation is mainly caused by cost-push inflation, with soaring energy prices due to the Russian-Ukraine war and supply chain bottleneck during covid-19 contributing mainly to the inflation. We then moved on to inflation projection by comparing different Phillips curve models and found that the Behavioural” new Keynesian Phillips curve (BNKPC) derives the most accurate predictions. The model incorporates both backward and forward looking to project the inflation rate, and we found that the short-term rate will maintain at 9.9–11.1% while the medium term is 3.49%-6.94%. Moreover, we explored the impact of Inflation on different income groups. As different income groups consume differently, the higher-income groups may be able to substitute for cheaper goods. In contrast, the lower-income group would not be able to do that. Inflation also affects households through wage rigidity, where household wages cannot keep up with price levels. We also explored HCI, which measures how much disposable income must change for households to keep up with changing costs and maintain the same living standard, which is a more representative measure of the impact of inflation on different income groups. Lastly, the disparities between the impact on different income groups have a broader impact on macroeconomic policymaking as it will be helpful information to improve the effectiveness of such policies.

This article was written by: Supeakcha Maskey, Curtis Wu and Sherry She, members of the Central Banking Society’s Economic Reseach Division. This article was reviewed by Yating Zhang, the present Head of Economic Research.

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