What Next for UK Inflation and the Economy?

Where does inflation stand now?

Inflation continues slowly to fall back to its 2 per cent target, although we are not there yet. Annual Consumer Price Index (CPI) inflation fell from 4 per cent in January to 3.4 per cent in February. Annual Core CPI inflation (i.e., CPI excluding energy, food, alcohol and tobacco) fell to 4.5 per cent in February from 5.1 per cent in January, goods inflation slowed from 1.8 per cent to 1.1 per cent, and services inflation eased from 6.5 per cent to 6.1 per cent. These are encouraging signs that inflation is on a downward trajectory from the highs we saw in mid-2022 and on track back to the 2 per cent target. The most important disinflationary contributor has been Energy Prices, which have fallen for the past 18 months. More recently, Food prices have also joined in to help sustain the disinflation process.

However, we should be cautious about counting our chickens before they hatch; while CPI inflation has been falling, core CPI and its components have fallen to a lesser extent. This reflects the underlying domestic inflationary pressures which are still present and pose upside risks to CPI inflation. Given that wages hold a higher weight in service-sector input costs, they are the main driver of services inflation. Therefore, the still-high wage growth, which is currently greater than core inflation, may continue to generate persistence in services inflation.

What are the key things to be looking for moving forward?

There are two sides to the coin regarding the evolution of the inflation. On the positive side, we can expect a 14 per cent fall this month in the energy price cap set by Ofgem. This reduction in the energy price cap, coupled with base effects of the ‘old’ high inflation we observed in early 2023 dropping out of the headline measure and easing food prices, will help push inflation below the 2 per cent target in the second quarter of this year. Additionally, July’s energy price cap, which is expected to be reduced further, will probably sustain the progress of disinflation. The confluence of these factors mean that we can expect CPI Inflation to be around 3.7 per cent in the first quarter of 2024 and briefly undershoot the 2 per cent target at 1.2 per cent in the second quarter, as highlighted in our Winter 2024 UK Economic Outlook. Looking at the broader picture, inflation will likely remain low, with some bumps in between, around the 2 per cent target unless upside risk stemming from geopolitical events materialises in a significant way. The geopolitical situation in the Red Sea remains tense. At the same time, the Israel—Hamas and Ukraine—Russia conflicts are still ongoing, which might lead to a larger and more prolonged rise in shipping costs and/or a resurgence of commodities prices. Nonetheless, the Bank of England might be inclined to opt for a wait-and-see approach, particularly with risks still skewed to the upside, though it is most likely that we will see three rate cuts this year given the data outturns we have witnessed.

What does this mean for monetary policy?

The Bank of England has maintained the current policy rate of 5.25 per cent since August 2023, after its most aggressive rate-hiking cycle since the 1980s. With headline inflation figures set to fall below the Bank’s target of 2 per cent for the month of April, there will be mounting pressure on the MPC to start loosening monetary policy, especially since the United Kingdom entered a shallow technical recession (defined as two consecutive quarters of negative growth) in the second half of 2023. Consequently, given the persistence of underlying inflationary pressures and potential upside risks to inflation, the MPC might be hesitant to cut rates prematurely and have to raise them again – which would risk de-anchoring inflation expectations. The MPC has reiterated that they would like to see sustained downward progress in headline inflation and underlying inflationary pressures before deciding on easing monetary policy.

Nevertheless, the coming months will give the MPC more clarity regarding their monetary policy decisions as data on pay settlements will be published, hopefully giving the MPC some confidence in the sustained decline in wage growth – ensuring it falls to a rate compatible with the inflation target. Additionally, in the recent April’s Decision Maker’s Panel (DMP) Survey published by the Bank of England – Wage growth expectations for the year ahead fell to 4.9% from 5.2% in February – the lowest reading since June 2022. Taken together with the disinflation we have been witnessing, it will fuel hopes that rate cuts are on the horizon. Our Winter 2023 UK Economic Outlook noted that interest rates could see their first reduction in May. That said, the last thing the MPC would want to do is to end up unwinding its decision and tightening monetary policy further down the road.

More importantly, what does it mean UK households?

The largest downward contributor to annual CPI inflation was food and non-alcoholic beverages inflation, which fell from 7 per cent in January 2024 to 5 per cent in February. This is a stark difference from the 15 per cent growth in food prices we saw a year ago. Together with falls in energy prices, this will impact households’ expenditure and thus is good news, especially for lower-income households who spend a larger proportion of their income on necessities like food and energy.

As inflation continues to abate and move along its downward trajectory, coupled with the still-high wage growth in part caused by the tight labour market, we expect aggregate real personal disposable income to grow as wage growth now exceeds price inflation. Annual growth in average weekly regular real earnings, which are adjusted to reflect the current rate of inflation, remained unchanged at 1.8 per cent in the three months to January 2024. This is encouraging news for workers whose real income has been squeezed by inflation since the end of 2021.

However, declining inflation does not mean goods and services are becoming cheaper. Prices are still rising and are still much higher than before the pandemic, but they are increasing more slowly relative to the past year. That said, these developments should provide households with some respite after the arduous cost-of-living crisis they have experienced over the past two years.