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Why is Inflation Worse in the UK than the EU?

Why is Inflation Worse in the UK than the EU?

Just this past Thursday, the Bank of England announced another increase in interest rates, lifting it from 4.25% to 4.5%. This marks the bank’s 12th consecutive raise, taking interest rates to a 15-year high. The primary reason behind these successive hikes is the effort to curb inflation, which, according to the latest data from March, is currently running at 10.1% in the UK.

While it’s true that most parts of the world are grappling with inflation rates higher than average, the situation in the UK is particularly severe. A look at the figures from the EU and the US reveals a stark contrast, with inflation at just 7% in the EU and now below 5% in the US.

This disparity prompts a deeper examination of the factors contributing to the UK’s high inflation rate, the effectiveness of the Bank of England’s strategies to combat it, and the potential impact of Brexit on this economic phenomenon.

Global Inflation Comparisons

When comparing the UK’s inflation rate with other countries, the extent of the disparity becomes even more evident. The UK’s inflation rate significantly overshadows those of the US and the EU as a whole. However, it doesn’t stop there; the UK’s rate surpasses every individual Western European country as well.

The country closest to the UK’s rate is Austria, with a year-on-year inflation rate of 9.2%. However, when we compare the UK to similarly large European economies, the difference becomes even more pronounced. Italy, for instance, has an inflation rate of 8.2%, Germany sits at 7.8%, and France is even lower, at just 6.6%.

These comparisons underscore the unique inflationary challenges the UK faces, setting the stage for a closer examination of the underlying causes, which will be covered in the subsequent sections of this analysis.

Why Is the UK’s Inflation So High?

To understand the distinctive inflationary situation in the UK, it’s crucial to dig deeper into the reasons behind its sharp rise. In our assessment, there are three main drivers: energy, food, and a tight labour market. Furthermore, the implications of Brexit have significantly amplified these issues.

The Energy Factor

Energy contributes to about a third of all inflation. British consumer energy prices saw a staggering 79% increase in March compared to their level two years earlier, the largest upsurge in Western Europe. This might be surprising, given the UK government’s so-called Energy Price Guarantee.

This cap on the price of gas and electricity ensures that the average household won’t exceed £2,500 in energy bills per year. Despite the heavy subsidisation, consumer prices remain high.

While the wholesale price of gas in Europe is back to pre-war levels, this reduction hasn’t translated into lower consumer prices in the UK.

A factor contributing to this is that the UK housing stock is poorly insulated, and the country relies more heavily on gas for heating than the average European nation. However, the primary culprit is the UK’s malfunctioning energy market.

The UK energy system operates on a marginal costing model. This system sets the wholesale price such that the most expensive producer can make a profit from their sales into the wholesale energy market.

Because gas generation costs more than, say, solar or nuclear, consumers end up paying more to safeguard gas-powered electricity producers. This discrepancy is why big UK energy producers posted record profits last year.

The Food Factor

fruit in trolley

Food accounts for a fifth of headline inflation, with food prices up by 19.2%. The main reason for the food price surge is the drop in domestic production, attributable to increased energy prices, poor government policy, and adverse weather conditions. The UK has had difficulties compensating for this production shortfall with imports.

The Tight Labour Market Factor

The third factor contributing to the UK’s inflation spike is a tight labour market. A shortage of workers drives up wages and the cost of services, which subsequently pushes up inflation. Since the pandemic, about half a million Brits remain economically inactive due to chronic pain and mental health issues. The UK has also witnessed a surge in early retirements, reducing the workforce and increasing the number of spenders.

To conclude, the UK’s high inflation can be attributed to these three factors, and the situation has been made worse by the fallout from Brexit. The UK’s energy market, rising food costs, and the tight labour market are significant contributors to the soaring inflation rates.

The Brexit Factor

Having explored the primary factors contributing to the UK’s high inflation, it’s imperative to consider a significant backdrop to this economic scenario – Brexit. Although not the main cause, Brexit has undeniably played a role in exacerbating the UK’s inflationary issues.

Brexit and Labour Shortages

One of the ways Brexit has impacted inflation is through exacerbating labour shortages. Research from the UK and a Changing Europe indicates that Brexit resulted in a shortfall of 330,000 people in the UK labour force.

This deficit includes a lack of seasonal workers for picking fruits and vegetables, partially explaining the significant rise in UK food prices.

Brexit and Trade Frictions

In addition to labour shortages, Brexit has introduced new trade frictions, making life more expensive for average Brits. These changes have also caused a depreciation in the value of the pound, making imports more expensive and further contributing to inflation.

In summary, while Brexit might not be the primary cause of the UK’s inflationary woes, it certainly hasn’t helped. Its indirect effects have potentially led to a situation where the UK’s inflation surpasses every other country in Western Europe.