By Tomasz Wieladek, chief European economist at T. Rowe Price
The UK’s inflation print came in hotter than many anticipated this morning, and I believe long-term consensus inflation forecasts for the UK and the euro area could start diverging throughout the rest of this year. The main reasons? Weak UK labour supply and investment following Brexit.
As gas prices come down sharply, both the euro area and UK will experience energy related disinflation, on top of powerful base effects from last year. However, there are more inflation drivers than just gas prices. Inflation, especially services, is also determined by local wage growth. Local wage growth is a function of supply and demand in the labour market.
These labour costs are eventually passed onto consumers. The price of labour depends on the difference of wage growth and labour productivity growth. For the BoE and ECB to hit their targets, this difference should not exceed 2%.
Stronger wage growth in the UK
Economists on the sell-side are starting to catch onto the idea that labour imbalances are more important than the unemployment gap in determining wage inflation. Evidence points to a clear labour shortage in the UK compared to the euro area, especially in the services sector. This is also reflected in a larger fraction of UK firms complaining about labour shortages. This has led to stronger wage growth in the UK (6-7%) than in the euro area (4-5%).
Despite the UK workforce being paid more per labour unit than euro area neighbours, the typical UK worker is producing less. This is likely a result of much weaker UK investment growth since Brexit, a view supported by many UK firms.
The consensus view among economists is that inflation in both the UK and euro area will converge back to roughly 2% by 2025. However, given the long-term labour and investment issues posed by Brexit, it is much more likely UK inflation will surprise euro area inflation to the upside looking ahead.