There’s a simple reason why inflation is persistently high

Inflation fell less than expected in April. The UK’s consumer price index was 8.7pc higher last month than in April 2022, down from 10.1pc in March.

While the Bank of England had expected a drop to 8.4pc, the market consensus was even lower at 8.2pc – given that wholesale energy prices have fallen sharply since spiking last spring, after Russia invaded Ukraine.

Headline inflation is now significantly lower than October’s peak of 11.1pc – a 41-year high. But “core inflation” rose from 6.2pc to 6.8pc last month, pointing to ongoing supply-chain price pressures beyond volatile food and energy costs. And that’s spooked financial markets since the inflation figures were released last Wednesday.

Government bond prices have plunged, with investors betting heavily on the Bank of England being forced to implement further interest rate rises. The base rate is now expected to increase from 4.5pc to at least 5.5pc over the coming months – jacking up mortgage costs. That’s a huge turnaround – this time last week, there was a widespread view the next move in rates could be down.

But with US inflation at 4.9pc and the eurozone average at 7.0pc, the UK now has the joint-highest inflation rate in the G7, alongside Italy. And for the first time in almost 20 years, Italy can currently borrow more cheaply than Britain, given how fast Rishi Sunak’s administration is chalking up liabilities.

A rising benefit bill and public sector pay increases saw the Government borrow £25.6bn in April, almost twice as much as the same month in 2022. The interest bill on the UK’s spiralling stock of national debt rose £9.8bn in April alone, enough to build 20 new hospitals – although those interest payments will be staged over future years.

Eyebrows are raising about the sustainability of the UK’s public finances, as inflation pushes up government borrowing costs – with gilt yields at levels last seen during the turmoil following last autumn’s mini-Budget.

And that begs the question: why is UK inflation so high? Far from “transitory”, as the Bank of England long insisted, price pressures in Britain are remarkably persistent.

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One reason is our tight labour market – with over a million vacancies still outstanding and a quarter of firms with 10 or more employees reporting worker shortages. This pushes up wages – with private sector pay 7pc higher during the three months from January to March and public sector pay up 5.6pc.

These pay hikes drive the “second-round effects” behind “core” inflation, feeding into broader price-setting as they push up company costs.

Spiralling grocery bills are also playing a role, with food price inflation still at an astonishing 19.1pc. This isn’t a uniquely British problem – the same measure was 21.2pc in Germany as recently as March.

But it’s odd that food bills are still rising so much, given that the index of global food prices compiled by UN’s Food and Agriculture Organisation, far from going up over the last 12 months, actually dropped by a fifth.

While the food supply chain is subject to lags, ministers need to ask the UK’s hugely powerful food retailers much tougher questions about the extent to which cost savings are being passed on.

Then there’s the Bank of England’s quantitative easing (QE) programme – which churned out £470bn of new money during 2020 and 2021, used to buy the government bonds financing extensive lockdown support measures.

That’s more QE in two years than during the previous decade since the 2008/09 financial crisis, when the policy was launched. And while pre-Covid QE stayed within the financial system, pumping up stocks and bond prices, lockdown-era QE was, via furlough and business support loans, channelled directly to ordinary firms and households, creating a much broader price-boosting wave of demand.

That’s why this new QE variant has fed into headline inflation to a much greater extent than its post-2008 predecessor – as this column has often argued.

But I’d say the main reason UK inflation remains exceptionally high is our still elevated energy costs. Monthly gas prices fell 1.0pc between March and April, according to the Office for National Statistics, compared with a rise of 66.8pc during the same two months in 2022 – as energy markets reeled from the war in Ukraine. Electricity prices over the same period were 1.1pc lower, in contrast to a rise of 40.5pc between March and April 2022.

While these patterns help explain why CPI inflation just fell, energy in the UK remains comparably very expensive – keeping headline inflation high.

The US, for instance, is benefitting from a huge expansion in domestic energy production, exploiting shale reserves. That’s why wholesale US gas prices were almost 80pc below those in Europe during 2022 and remain much lower now.

End-user electricity prices in the UK, though, at €46.65 per kilowatt hour, are still twice the European average – with prices at €27.18 and €21.01 respectively in France and Spain.

One explanation is the ongoing “green levies” on UK utility bills, used to subsidise the transition to renewable energy – charges which have been suspended during this tough period across other major European economies.

The UK also uses a marginal cost pricing model – which keeps energy bills high. While it’s true that solar and wind power generated around a third of electricity used in Britain during the first quarter of this year – marginally more than gas, in fact – supposedly “cheap” renewables, far from cutting energy costs, are pushing prices up.

That’s because renewables not only still depend heavily on subsidies, but also on having a large fleet of gas power stations on standby, which can be literally fired up on the large number of days when the wind isn’t blowing and the sun isn’t shining. Running this dual system is hugely expensive – and helps explain why the price of all UK electricity, however generated, is driven by the spot price of gas.

The reality is that renewable companies make money from the very intermittency problems they are supposed to be trying to solve – providing few incentives for them to come up with viable energy storage solutions.

And this, in turn, is a major reason why, despite last week’s reduction of Ofgem’s “energy price cap”, lower wholesale energy costs won’t be translating into much cheaper electricity for firms and households, and decisive falls in headline inflation, any time soon.

Follow Liam on Twitter @liamhalligan

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