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Why is Spain’s inflation so much lower than the UK’s? Because it stood up to business

Carsten Jung

The reliance on Bank of England rate rises alone can’t go on. In other countries, rent caps and excess profit taxes are working.

The government seems to be claiming that it’s winning the fight against inflation. But we are not out of the woods yet. Inflation currently is still far too high and the Bank of England has increased rates again to 5.25% and lowered its growth forecast. But it doesn’t have to be like this. The case of Spain is a great counter-example. Its inflation has just fallen to the 2% target. How is it that it has already achieved this important milestone?

The reason is more forceful management of the economy – the Spanish government took quicker, more concerted action than ours did. Spain capped energy prices by more than the UK, lowered the cost of public transport, taxed excess profits and put in place limits on how much landlords can raise rents. While also coming with costs, this kept inflation from spreading more widely and more persistently than elsewhere.

Similar measures would have made a big difference here. One year ago, at the Institute for Public Policy Research, we argued for a similar approach in the UK, of using fiscal policy to reduce prices directly. But the call was only partly heeded, in the form of energy price support measures. While in Spain energy price caps are set to continue into next year, in the UK, the degree of support has already been lowered, covering fewer businesses than previously, and is set to end completely in autumn.

Pubs, restaurants and other businesses have had to bear the full brunt of still very high electricity costs since this spring. With the possibility of another energy price spike this winter, the government should give households and businesses certainty by extending energy price support measures and assure them that they will be protected from another price shock.

As it stands, the onus is now exclusively put on the Bank of England to stabilise UK inflation. The justification for this is that it is an overheating economy that is causing high inflation – too much money chasing too few goods. But what we’re seeing could alternatively be explained as “pass the parcel inflation”. This is the theory that, rather than a red hot economy, inflation is the result of businesses and people trying to pass on higher costs to others, if they can. Bank of England analysis partly confirmed this, finding that about three-quarters of inflation stemmed from people passing on high energy and food prices at the end of 2022.

But there was huge inequality in who was able to “pass the parcel” on inflation.

The Bank of England recently highlighted that wage growth was “concentrated in higher-paying sectors such as financial and business services” while “pay growth in lower-paid sectors like wholesaling, retailing, hotels and restaurants had been broadly flat”.

Moreover, while there has been an all-present focus on wages, there has been too little attention paid to the role of businesses in keeping price pressures up by “passing the parcel”. In forthcoming IPPR analysis we show that a large chunk of businesses have either maintained or increased their profit margins in 2022. At the same time, many landlords were able to raise their rents in line with inflation – something that the temporary rent control policy in Spain was able to contain. If the costs of inflation were fairly shared, businesses and landlords would also take a hit and absorb some of the costs, rather than workers taking most of the hit.

In countries such as Japan, there is greater societal pressure for businesses to lower prices when input costs come down, and to absorb some of the higher costs themselves. France has taken policy action, making sure that food manufacturers and supermarkets play their part. Eminent institutions such as the Bank of International Settlements say that businesses reducing their profits is key for inflation to come down.

Back in the UK, further Bank of England rate increases can, ultimately, be effective in bringing down inflation, as businesses will find it harder to put up prices and people harder to bargain for higher wages. But this comes at a high cost. It means fewer jobs, higher mortgage costs and lower growth in the future. A more balanced approach – including through measures like Spain’s – would make this less necessary.

The Bank is very possibly already overdoing it. A lot of the interest rate hikes are yet to ripple through the economy. The Bank expects the effects of this to take a full one and a half years to feed through. This means that, next year, we might be in a situation where the economy is slowing down drastically with inflation already coming down more quickly.

There are some signs that this might be happening. The UK’s largest fund manager is now betting on the UK going into recession next year. In the labour market, vacancies have started to fall and unemployment is ticking up. Consumer sentiment is down. Meanwhile, global growth is slower than expected and so is unlikely to bring relief. One year from now, “pass the parcel inflation” might be over, but further Bank of England interest rates might also have killed the recovery.

It is not too late to change course. The Bank should hold off from further rate rises and even consider lowering them soon. The government should follow Spain, doing more to hold energy prices down, making businesses play their part, and supporting renters. Spain shows that inflation can come down without the economy going into tailspin. The UK should attempt the same.

Carsten Jung is a senior economist at the Institute for Public Policy Research’s Centre for Economic Justice

Investment Synergy - pass the parcel..... more like at times, pass the buck! Cultures and country economics vary, some work some don't, but its time for a proper fix...

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