- Forecasts suggest that UK inflation should halve over the next 12 months
- But economists warn that there could still be surprises in store
Can we really be confident that inflation is on its way back down? Rishi Sunak seems to be. In an early January speech, he set out his priorities for the UK – and inflation had top billing. Sunak pledged that “we will halve inflation this year to ease the cost of living and give people financial security”. Despite introducing no new policy measures, Sunak pledged that “these are your government’s priorities. And we will either have achieved them or not”. Has he made himself a hostage to fortune?
At the time of going to press, UK inflation was at 10.7 per cent, meaning that for Sunak’s objective to be met, consumer price index (CPI) inflation must fall to 5.35 per cent by the end of the year. At first glance, this seems to be a fairly safe bet, as the chart below shows. The Bank of England forecasts that inflation will fall to 5.2 per cent by Q4, due to falling energy prices, increasing ‘economic slack’ and rising unemployment. Consensus estimates from the Treasury put the figure slightly lower at 5.1 per cent, while the Office for Budget Responsibility (OBR) forecasts see it falling to 3.8 per cent, thanks to differing assumptions about the path of interest rates.
What’s more, research from Goldman Sachs suggests that, globally, inflation may be in retreat. Its analysts found that the share of countries experiencing an upside “inflation surprise” had climbed from 25 per cent in 2020 to over 65 per cent in 2022. But now this figure seems to be in retreat. The analysts note that “over the last few months, global inflation surprises have swung broadly negative, indicating that price increases have cooled more than many economists expected”.
The end of sharp interest rate hikes?
This could bring some welcome relief for investors, especially if it marks the end of the sharp interest rate hikes that markets weathered last year. We may see bond prices rise and yields fall as central banks soften their stance, meaning a more favourable environment for risk assets, too. But in reality, a huge amount of uncertainty remains.
Firstly, inflation could surprise again. Deutsche Bank senior economist Sanjay Raja expects inflation to “remain stubbornly resilient” on the way down, landing closer to 6 per cent by the end of the year – missing Sunak’s target by a clear margin. KPMG economists also note that “the path of inflation remains uncertain”, identifying the potential for both higher and lower-than-expected figures ahead. Supply shocks and domestic price pressures could see CPI stay high, but falling energy prices and a global slowdown could also combine to “push inflation below the Bank of England’s 2 per cent target”.
This uncertainty leaves investors in a difficult position. Chris Iggo, chair of the AXA IM Investment Institute, poses the question of “whether to hold back investing cash until there is another (probably inevitable) setback, or take the view that there is more upside to come as the balance between inflation and growth improves”. Unfortunately, there are no easy answers. In a climate of such uncertainty, he reminds us that “you can only invest in what’s in front of you”, and notes that assessing value, risk and whether expected returns meet your financial goals remains vital.
Energy bills still a drag
It is also worth noting that, paradoxically, lower inflation does not necessarily mean the end of the cost of living squeeze. A new report from the Resolution Foundation found that the financial year ahead should see inflation “fall rapidly”. But this welcome trend will be offset by a range of other headwinds: even as the price level cools, households will struggle with higher taxes and rising mortgage costs. Despite falling wholesale prices, energy bills could also prove a drag – the think tank expects slimmed-down government support to see typical energy bills rise from £2,000 to £2,850 next year.
This might mean a tough year ahead for retail and hospitality: the Office for National Statistics reported in December that two-thirds of adults are spending less on non-essentials due to the rising cost of living. Even if inflation does halve over the course of the year, it won’t be business as usual for some time yet.
