2022 has been a year of highs, but the high in this regard is inflation. The prices of goods and foodstuff have been skyrocketing at an alarming rate. This has directly had an impact on the cost of living of UK citizens and beyond. Inflation is determined by how much goods and services have increased over a given period.

To better explain how inflation works. When you say there has been an inflation rate of 7%, it means that the prices of goods and services is 7% more expensive than in the past year.

This means the cost of living is directly impacted by an increase in the inflation rate.

The Bank of England on May 5 forecasted the highest inflation in the country since 1982 will happen by Q4 2022. They forecasted that the inflation rate will peak by slightly over 10%. They projected that inflation will be at about 9% in Q1 2023, before reducing to 3.6% by the end of 2023 and below 2% in 2024.

1.  Relationship between the cost of living and inflation

Cost of living is the amount needed to maintain a standard of living. Though inflation directly impacts your cost of living, it is not the only variable affecting it. Another variable that affects the cost of living is how expensive a particular area is.

Factors like rent cost, house cost, healthcare, taxes and transport also play a hand in changes in the cost of living. For example, living in a city like London is more expensive than in Hereford, West Midlands and Derry, Northern Ireland.

Some unexpected chain of events can also affect the cost of living in a particular area. During the Covid-19 pandemic, for example, more people had decreased the cost of living because they didn’t have to commute to work.

In an instance where global warming becomes extreme, people in cold countries won’t have to worry about heating anymore. This will reduce the amount they spend.

People in hotter countries might have to invest in air-conditioning. This will increase the cost of living in this region.

2.  Drivers of Inflation

In 2022, there have been three main drivers of consumer price inflation. They are

• Transport
• Food and non-alcoholic beverages
• Housing, electricity, water and similar bills

These three drivers account for more than 50% of the Consumer Price Index.

In May 2022, Consumer Prices were 9.1% higher than in the same period in 2021.

Since April 2022, the Ofgem price cap rise has been directly responsible for the increase in “housing, water, electricity, gas and other fuels”.

Between April and May 2022 alone, the price of this driver increased by over 46%, with a further increment experienced in May.

Motor fuels have played a big part in the high cost of transport in recent months. The annual growth rates for petrol and diesel reached 32.8% in May 2022. This was the highest rate ever recorded since the inception of consumer price inflation in January 1989.

Energy prices, including household tariffs and petrol costs, have also played a role. Between May 2021 and the same period in 2022, there has been a domestic gas price growth of 95%. Domestic electricity prices have also gone up by 54% during this period.

Another factor that affects the cost of living through inflation is political conflicts. An example is how much Russia’s invasion of Ukraine has affected the world’s economy.

The warring countries, Russia and Ukraine happen to be one of the largest producers and exporters of agricultural goods like wheat and metals.

These conflicts and sanctions put on a country like Russia mean these products cost more on international markets.

This has led to an increase in food and material prices in countries like the UK.

3.  Inflation vs real wages

When talking about inflation, it is important to take income into account. What then is the relationship between income and inflation?

If your income is higher than the inflation rate, you will have less to worry about in terms of the cost of living. But if income isn’t increasing at the same pace as inflation then it becomes a problem.

For example, imagine we have an inflation rate of 6%, but the average income also increased by 9%, then the real income would have increased by +3%. This means that inflation has increased but the cost of living won’t affect the family much.

4.  Why the cost of living may rise more than inflation

Energy, transport and food have been the main drivers of consumer price inflation. The problem with this is that these drivers are essential expenses for most households and can’t be done without.

Yes, ways of reducing how much they take up from your income can be found but it has its limits. Higher-income households have an advantage here as they can swap their non-essential spending to cover these necessities.

Not many small-income households have that opportunity.

It is very possible to have a case whereby the cost of living becomes higher than the inflation rate.

Inflation is the measure of the purchasing power of money in an economy. The same is through for households.

A low-income family may spend much of their income on basic food items, rent and fuel for example. The cost of living for these families would easily be higher than inflation if the cost of these essentials increases at a faster pace than inflation.

The cost of living has been increasing faster than inflation for some basic essentials. Jack Monroe, a food campaigner said basic foods rose higher than the official inflation rate between 2021 and 2022.

However, this year, higher-income households have experienced higher inflation rates than low-income families. The reasons for this are simple.

Higher-income households tend to spend more to maintain their standard of living. This means spending more on transportation as they use personal cars instead of the public transport system.

The consequence here is spending more on fuel as the price of motor fuels has drastically increased over the past year.

Other areas higher-income households are spending more on are energy, recreation, hotels, restaurants, and lifestyle.

5.  How Government policies are helping

The Chancellor announced measures taken to support households in February, March, and May 2022. The support was estimated at £37 billion and includes:

• Given a £400 relief off energy bills for households
• Households receiving means-tested benefits were given £650 plus a £300 payment for pensioners and people receiving disability payments were given £150
• Giving a 5p cut to fuel duty
• Households in council tax band A-D were given a £150 tax rebate
• The threshold at which NICs charged on earnings was increased

Both National Insurance contributions (NICs) and income tax experienced tax rises by the Government in April 2022. The net level of government during this period is estimated to reach about £14 billion in 2022/23 when the changes are included.

In May 2022, 88% of adults in Great Britain experienced a rise in their cost of living, according to the office of the National Statistics.

Office for Budget Responsibility (OBR) in its March 2022 forecast suggested that household income taxes after tax and adjusted for inflation to begin lowering in Q2 2022 will not recover till Q3 2024.

Since lower-income families spend more of their income on energy, food, and transport, they are expected to be affected more by the changes in the cost of living. That is why the recent Government support for households was created around benefiting lower-income households the most.

According to the Resolution Foundation, the measures in place by the Government to support households will remove 82% of the rise in households’ energy costs in 2022-2023. This number is expected to increase to over 90% for poorer households.

Low-income households spend a larger proportion than average on energy and food so will be more affected by price increases. Overall, recent Government support for households benefits low-income households the most.

The Resolution Foundation estimate that the measures announced to support households this year will “in effect offset 82 per cent of the rise in households’ energy costs in 2022-23, rising to over 90 per cent for poorer households”.

Shrinkflation knock-on effect of inflation

When inflation happens, companies and brands tend to compensate for the lower purchasing power of customers with shrinkflation. Companies intentionally reduce the size of their products so it is still affordable for all.

What began as speculation and the subject of debates by financial experts and institutions is fast becoming a model that central banks are now embracing. Central banks are now considering digital currency as a cryptocurrency alternative.

No doubt the exponential increase of Bitcoin price since its inception in 2009 is a big reason why central banks are now working towards developing their own cryptocurrency.

It is important to also acknowledge that cryptocurrency has continued to grow in strength. This is even with the fact that central banks initially disparaged it and gave it bad publicity. China even went as far as barring banks from using it.

We also had famous economist Paul Krugman calling it evil.

But today we have more than 85% of central banks around the world working on the digital versions of their respective currencies according to PwC.

A question that comes to mind is the difference between conventional digital currencies and central bank-issued digital currencies. The main difference is that cryptocurrencies rely on distributors like blockchain while digital currencies will be issued like banknotes by central banks.

So maybe the whole thing is about wrestling back control to the Government. I’ll explain this later.

Why Digital Currency?

Why have central banks all around the world suddenly made a U-turn on their stance on cryptocurrency? Why are working groups being set up to discuss the merits of Central Bank Digital Currency (CBDC)? Could it be because of its popularity or price increase around the globe?

The answer to that question is both. Stay with me as I shed more light on this.

China was one of the first countries to bar the use of cryptocurrency but it is also leading the race for its own digital currency. In fact, they have been researching this initiative since 2014. They have also issued more than $300 million worth of digital renminbi into their economy. Digital Renminbi (RMB) is China’s digital currency and is the first by a major economy. Trials have even been carried out in cities like Shenzhen, Chengdu and Hangzhou.

Christopher Giancarlo, the previous chairman of the U.S. Commodity Futures Trading Commission had some really interesting things to say about RMB. According to him, people will use digital RMB as a payment option for shopping, buying meals and staying in hotels by Winter Olympics in 2022.

Other countries have taken note of the strides China has made in their digital currency experiment. They are also now open to the possibilities but many are playing catch up.

Bank of England released a roadmap to a digital pound sterling. According to the bank’s chief economist, Andy Haldane, the move can help the UK’s COVID-stricken economy by benefiting from negative interest rates.

The US has also started talking about the possibilities of a digital dollar. This was in part due to the actions of commercial banks. Leading banks like JP Morgan already employed the use of cryptocurrencies for cross-border payments and settlement.

Sweden is in a race to be the first cashless nation by 2023 and is lining up its own digital currency named ‘e-krona’.

Recently, El Salvador’s president announced his plan to make Bitcoin currency a legal tender in the country.

Why The Cryptocurrency Scare?

Two factors seem to be pushing world powers to adopt their own digital currency. The first is the need for a global regulator to lay down the law in the expansive cryptocurrency world. The second is to prevent rogue players from doing it first.

We already countries like Venezuela and North Korea pushing digital currency agendas. North Korea has already launched Petro, their digital currency, as a means to bypass US sanctions.

Other factors influencing digital currency momentum is the promotion of financial inclusion, easier cross-border transactions and payment system stability.

It would come as a surprise that Bitcoin isn’t the main threat to central banks. Even with its $2.2 trillion worth. This is because BTC is very volatile and the blockchain network is slow.

Stablecoins is what central banks are most worried about. This is because they are digital currencies backed by stable assets like gold.

A CBDC backed by gold is already being considered by the Russian government.

Financial and technology companies have also started looking at the possibility of integrating stablecoins into their platforms.

The most popular and largest stablecoins at the moment is Tether. It has about $51 billion worth in circulation.

Adding to this is the potential competition launch of the Facebook backed stablecoins, Diem. It has also garnered support from Uber and other companies.

Why are stablecoins feared? Well, it’s really simple. We know by now that people hold BTC as a store of value. Now imagine when people do that and start transacting more in stablecoins. What we are looking at is a rapid fracture of money and payment systems.

This is why central banks and governments are looking at the options of digital currency. It is so they do not lose control of their monetary policies. Without monetary control, they can’t monitor inflation and financial stability.

People and businesses can also benefit socially and economically from digital currencies. More effective monetary policies, lower transaction fees for businesses and consumers and potential reach to bankless people are some benefits.

Economic policies like stimulus checks can also be targeted more properly through CBDC. Since digital currencies are programmable, stimulus checks can have a deadline. This way you have to spend before it vanishes and it will help boost the economy.

CBDC can also potentially help reduce money laundering and similar illegal activities.

Privately issued digital money can’t be stopped but CBDC can help level the playing field.

Challenges of Digital Currency

Technological issues apart, there are some concerns that digital currency would have to overcome. Such an example is a privacy concern. Since its government-owned, CBDC could make it easier to spy on private transactions.

Another challenge is how to please commercial banks. This is because by adopting a digital currency, central banks would be in direct competition with banks for deposits. This can cost them interest income on assets and raise funding costs. Compensating banks for CBDN services is a proposal that has been received to address this concern.

Datastream and client relationships are important for banks to sell financial services to generate revenue. This can be disrupted by the CBDC.

Some central banks are however working to limit consumer holdings of digital currency. ECB for example is contemplating a consumer holding of between 3000 euros to 3600 euros.

Banks can also employ the use of CBDC.

Conclusion

Cryptocurrency is growing in popularity and will continue to do so. Bitcoin especially has shown tremendous value increase over the years. Add the emergence of stablecoins then it is understandable why central banks have taken note.

It isn’t about wanting a slice of the cake. It is more about levelling the playing field and being able to monitor and exert control by the government.

Having a digital currency is a good prospect for most countries. But that is open to the concern of if they can get it right. With China leading the charge, it won’t be long before other major economies jealously accelerate their own development.