Can we halve inflation (again)?

Data released this week showed that the headline UK inflation rate had dropped below 5 per cent for the first time in two years. The Bank of England (BoE) will be pleased that rate hikes seem to be paying off. The prime minister will also breathe a sigh of relief that his target of halving inflation by the end of the year has been met.

But just last month, BoE governor Andrew Bailey warned reporters: “Let’s not get carried away, there is an awful lot still to do.” He’s not wrong: the inflation target is 2 per cent, meaning that we need to halve the inflation rate again before we can really claim victory. The problem is that this next push could prove even more difficult.

A year ago, consumer price index (CPI) inflation peaked at an eye-watering 11.1 per cent. Yet once volatile food, alcohol, tobacco and energy prices were stripped out, ‘core’ inflation for the same month was a more manageable 6.5 per cent – as the chart shows. In simple terms, last year’s inflation was largely driven by soaring food and energy prices – which have now started to cool. 

When we talk about inflation figures, we quote the annual rate, which is the sum of the 12 most recent month-on-month changes. Each month, the figure from this time a year ago drops out of the calculation. Last October's soaring energy and food prices are dropping out to be replaced by far lower numbers, flattering the latest inflation figures. 

And research from the Office for National Statistics (ONS) suggests that this shouldn’t come as a surprise. In August, analysts found that while prices for liquid fuels, gas and electricity fluctuate wildly, they are typically only weakly correlated with the persistent underlying rate of UK inflation. In other words, although these prices often moved the headline inflation rate, they provided a very weak signal about the true inflationary pressures facing the economy (see table). 

The inflation rate for restaurants and cafes, on the other hand, was found to be an excellent proxy for the underlying trend in inflation – as was hairdressing and personal grooming. This is no coincidence: service price inflation tends to send a very clear signal about underlying inflation, by reflecting domestic wages (and therefore workers’ inflation expectations) rather than, say, the more volatile cost of imported goods. As a result, it tends to be an important driver of core inflation rates. 

As the impacts of energy and food price surges subside, high headline rates will give way to stubborn core CPI inflation figures. Services inflation is forecast to remain well above 6 per cent in next week's figures. The good news is that core CPI is a better match for the BoE’s policy toolkit than spiking energy prices were. Economists at the NIESR think tank say that these measures reflect the component of inflation that “the Monetary Policy Committee wants to, and can, return to the 2 per cent target through using its conventional monetary instrument”. 

The bad news is that now that price pressures have permeated to other areas of the economy, the ‘second-round effects’ could prove harder to address. NIESR economists think that despite higher interest rates, “we are likely to see inflation remain persistently elevated throughout 2023 and into 2024 as a result”. The BoE’s most recent forecasts now see inflation returning to target by the end of 2025 – rather than the beginning. As such, the government could well start 2024 with a familiar aim: to halve inflation again by the end of the year. This time, it might be a tougher task.