Is UK inflation still on track?

Latest UK inflation figures proved underwhelming. The headline rate dipped from 3.4 to 3.2 per cent in March, while closely watched services price growth fell by just 0.1 percentage points to 6 per cent. As a result, concerns are mounting about a US-style ‘difficult last mile’ back to the 2 per cent target. 

The US inflation rate has hovered around 3.5 per cent for months. Markets now fear a similar situation in the UK – spelling higher for longer interest rates. Traders pushed back bets on a first UK rate cut to November immediately after the latest release. Yet there is still reason to hope that they could come far sooner than this. 

Economists expect inflation to drop significantly next month thanks to base effects and a fall in the Ofgem price cap. Household energy bills fell by 12 per cent at the start of April and economists expect another drop when the price cap is reset again in July. Forecasts aggregated by consultancy Consensus Economics suggest that price growth will fall to 2.1 per cent in April and 1.8 per cent in May. 

Bank of England (BoE) governor Andrew Bailey also made some encouraging statements at the International Monetary Fund (IMF) summit on 16 April, noting strong evidence that the disinflationary process was “working its way through”. Analysts at Dutch bank ING said that the change in market expectations seemed “extreme given the recent dovish comments from governor Bailey”, and continue to expect a first rate cut in August. 

Tellingly, Bailey also highlighted the different UK and US macroeconomic backdrops, stressing that inflation dynamics in the US were more “demand led”. IMF economists expect the US economy to grow by 2.7 per cent this year, and see signs of “strong demand in an economy that remains overheated”. The UK, meanwhile, is still operating below full capacity, and the IMF forecasts real gross domestic product (GDP) growth of just 0.5 per cent in 2024. 

In theory, this should make UK inflation easier to quash. But there are still enough signs of sticky prices to worry the more hawkish members of the Monetary Policy Committee (MPC).

The last mile won’t be easy

Wage growth remains high at almost 6 per cent – as does services inflation. Last week, BoE rate-setter Megan Greene argued in the Financial Times that inflation would stay elevated in the UK thanks to the “double whammy of a very tight labour market and a trade shock from energy prices”. She added that “rate cuts in the UK should still be a way off”.

The escalating conflict in the Middle East has raised the prospect of another energy price shock, and could add to the sense of caution. For now, analysts at Capital Economics think that “while risks surrounding the Middle East might lead central banks to strike a more cautious tone, we do not yet expect them to change their plans significantly”. They still see a June rate cut as a possibility in the UK if inflation falls as expected over the next few months. 

Although we can be fairly confident that inflation will return to target next month, forecasters are split on whether it will stay there. Analysts at ING expect the consumer price index (CPI) inflation rate to fall to 1.6 per cent in June and stay below target for most of 2024. Deutsche Bank chief economist Sanjay Raja sees a more “bumpy path ahead”, and doesn’t expect a sustained return target until spring 2025. The BoE’s latest forecasts also imply that inflation will return to the 2 per cent target this spring, before rising later on in the year – as the chart shows. 

The uncertainty comes in the wake of a report into the BoE’s forecasting practices by former Federal Reserve chair Ben Bernanke. The review found that out-of-date software was leading to “deficiencies in the Bank’s forecasting infrastructure”, and set out 12 recommendations to improve forecasting and communication. Although the BoE has pledged to act on all of them, change looks set to be slow, with the BoE only promising an ‘update’ by the end of the year.