- Last month’s reacceleration should prove short-lived
- But even if inflation is on the way down, its path could be bumpy
After peaking at 11.1 per cent last October, UK inflation had been on a slow but steady downward path, falling to 10.1 per cent by January this year. But last month’s data delivered an unpleasant surprise: the rate of inflation had re-accelerated to 10.4 per cent.
Why did UK inflation rise again?
Over the past few months, the bulk of UK inflation has been driven by rising prices for gas, electricity and fuel, food and drink, and restaurants and hotels. Between them, these categories accounted for almost 70 per cent of last month’s figure. Other categories, such as alcohol and tobacco, and clothing and footwear, are also contributing to today’s high inflation rate, although on a far smaller scale.
But it was these smaller drivers that caught us off-guard: the Bank of England (BoE) said that most of the “surprising strength” in last month’s figures was driven by changes in clothing and footwear prices. Encouragingly, though, these “tend to be volatile” and could “prove less persistent” as a result.
Despite last month’s shock, BoE governor Andrew Bailey said that the BoE expects to “see a sharp fall in inflation during the course of this year, probably starting in a couple of months or so from now” as the impact of higher energy prices unwind. There are positive signs from other data points, too. Other measures of inflation (including the Producer Price Index) point to easing pressures, while earnings growth is slowing.
Konstantinos Venetis, director of global macro at TS Lombard, also notes that “sustained falls in energy prices will amplify the favourable base effects that are about to kick in” to inflation figures. Because the consumer price index (CPI) rose at a high rate last year, even a similar absolute increase in the price index this year would result in a lower inflation rate now, simply because the annual percentage increase would be calculated using a higher base. This means that the mechanics of inflation calculations should apply some significant downward pressure to figures in the months ahead, too.
Are higher interest rates working?
Inflation is so far above the BoE’s 2 per cent target that it might not feel as though raising rates is working. Bailey acknowledged last week that “monetary policy cannot make the shocks to our national real income go away”, although he added that it can ensure that “inflation that has come to us from abroad does not become lasting inflation generated at home”.
The problem is that monetary policy works with long time lags, meaning that the impact of earlier hikes are only just starting to feed through. This makes it hard to judge how much more the Bank’s rate-setters need to do.
In last month’s monetary policy committee (MPC) meeting, seven members voted in favour of a 25bps rate hike, noting that inflation figures had “surprised significantly on the upside”. Two voted to keep rates unchanged, arguing that “the lags in the effects of monetary policy meant that sizeable impacts from past rate increases were still to come through”.
Bailey said last week that the Bank has to be “very alert to any signs of persistent inflationary pressures”, and added that “further monetary tightening would be required” if they became evident. Market pricing suggests that investors still expect the MPC to increase the base rate by a further 25bps to a peak of 4.5 per cent, before cutting interest rates by the end of the year.
Where will inflation go next?
Despite last month’s unpleasant surprise, there is broad consensus that UK inflation is on its way down. The Office for Budget Responsibility (OBR) forecasts that inflation will decline rapidly this year (see chart), as does the BoE.
But although we can be relatively sure that we are over the hump, it is less clear what the road back down will look like. Modupe Adegbembo, G7 economist at Axa Investment Managers, said that although last month’s reacceleration is unlikely to persist, the surprise did signal “the real risk of inflation remaining sticky on its descent”. TS Lombard’s Venetis agrees that the path of inflation’s decline remains to be seen, and added that “it is unrealistic to expect inflation to fall in a straight line”.
