Economic update: Ukraine crisis adds to inflationary pressures

High and rising inflation has been a recent feature of the UK economy, with prices rising at their fastest pace in 30 years. The economic side effects from Russian military action in Ukraine may result in further inflationary pressure in the months to come.

This Insight covers the potential impact on the UK economy from the conflict in Ukraine, latest developments in inflation, monetary policy and GDP growth.

Economic effect of Russian invasion of Ukraine

Russia’s military action in Ukraine will also have implications for the world economy. For the UK, the most likely economic impact, at least initially, will come through higher energy prices.

The Library continues to publish briefings on the crisis in Ukraine, including on aid, international law and NATO’s response.

Russia is one of the world’s largest producers and exporters of oil and gas and an important supplier of gas to many European countries, though not to the UK. Immediately following the attacks on 24 February 2022, oil prices went above $100 per barrel to their highest level since 2014. Gas prices on international markets also increased sharply, including for UK natural gas. There is a great deal of uncertainty as to how sustained these, and any further, price increases may be.

Further inflationary pressure possible

For the UK, higher energy prices would first be felt in petrol prices and then potentially energy bills (for businesses, as well as households). Food prices may also rise, as Russia and Ukraine are important producers of various agricultural products, such as wheat.

If inflation does rise further, this would put additional pressure on household budgets and increase business costs. Consumer and business confidence could also be hit. More caution could result in the public spending less, lowering economic growth.

It’s too early to be confident about what the overall economic impact on the UK will be. However, the Bank of England in its early February review of the economy, warned that “[h]igher energy prices would further restrain growth in global and UK activity”.

Inflation already at 30-year high

The speed at which consumer prices rise, the inflation rate, rose to 5.5% in January compared with a year ago. This was up from 5.4% in December, and up from only 0.7% in January 2021. It was last higher in 1992.

The Bank of England estimated that half of the increase seen over 2021 was due to higher energy prices (PDF). Increases in the costs of consumer goods also contributed.

Prior to the conflict in Ukraine, inflation was expected to peak in April 2022. This is when the new default price cap on household energy bills comes into effect in Great Britain. The price cap will be 54% higher than it is currently, likely pushing inflation over 7% in April. Taxes will also rise in April, as National Insurance Contributions go up by 1.25 percentage points.

On 3 February the Chancellor announced a package of measures to reduce some of the effect of higher energy bills. This includes a one-off £150 rebate in April to most households who pay council tax and a one-off £200 reduction in energy bills this autumn that has to be repaid over the following five years.

Interest rates raised

In response to higher inflation, the Bank of England raised interest rates twice in recent months. From an all-time low of 0.1%, rates first were lifted to 0.25% in December 2021 and then to 0.5% in early February 2022. This is still below what they were (0.75%) heading into the pandemic.

Further rate hikes are expected, as the Bank attempts to lower the risk that inflation remains persistently above its 2% target. Higher interest rates increase the cost of borrowing, typically reducing demand in the economy. In turn, this reduces pressure on firms to raise prices.

Effect of Omicron on economy was mild

Due to the surge in cases of the Omicron variant of the coronavirus, monthly GDP fell by 0.2% in December 2021 compared with November. Consumer-facing services felt the brunt of the downturn as people cut back on going out.

For the same reason, GDP growth in January is also expected to have been weak, although the impact of the Omicron variant on the economy has been relatively mild.

More recent indicators of business activity, such as IHS Markit’s survey of purchasing managers for February, have been relatively upbeat. The labour market also continues to recover from the pandemic.

The main risk to the outlook is high inflation and its impact on spending. Cost of living concerns led to consumer confidence in February, as measured by GfK, falling to its lowest level since January 2021.

Household budgets will continue to be squeezed in coming months. How much this results in more restrained consumer spending growth will be crucial in determining UK economic prospects in 2022.

About the author: Daniel Harari is a researcher at the House of Commons Library, specialising in UK and international economies.

Photo by KWON JUNHO on Unsplash