What we know about inflation, and what we don’t

After whirlwind of double-digit inflation readings and interest rate hikes, the dust is starting to settle.

Following last month’s encouraging price growth data, the Bank of England (BoE) voted not to raise interest rates for the first time in almost two years. As such, it seems like a good time to stop and take stock: after an extraordinary period, what do we now know about UK inflation? And what big questions remain?   

The causes of high inflation 

According to the BoE, soaring inflation was caused by three shocks: the Covid-19 pandemic, large increases in energy prices and a fall in the labour force following the pandemic. Although these forces were global, the UK faced a particularly unpleasant combination: earlier this year, BoE rate-setter Jonathan Haskel said that “the UK has a US-style tight labour market, and a European-style tight energy market”.

Energy price inflation has largely eased, but policymakers remain concerned about the UK’s labour market. Wage growth is now outstripping the rate of inflation, with weekly earnings growth (excluding bonuses) at 7.8 per cent. Rate-setters now worry that high wage growth could fuel services inflation, making it more difficult to drive overall inflation back down to the 2 per cent target. 

Despite this, August’s figures were better than expected, with the headline rate of annual inflation dipping from 6.8 to 6.7 per cent. While this was only a small deceleration, it was far better than the uptick, due to rising fuel prices, that many analysts and forecasters had anticipated. In the end, although rising prices for motor fuels did cause an upward contribution – adding around 0.3 percentage points to consumer price index (CPI) inflation – this was offset by lower rates of food price and accommodation price growth. 

Interest rates are starting to impact inflation 

One of the biggest surprises in August’s inflation release was the fall in services inflation, which dropped from 7.4 to 6.8 per cent. The BoE sees services inflation as a key barometer of domestic price pressures, and a signal of inflation persistence. Following the release, economists at Capital Economics said that the drop would give rate-setters “some encouragement that higher interest rates are working”. 

And it did. September’s interest rate vote was close, with five of the Monetary Policy Committee voting to hold rates constant, while four favoured a further hike. The committee weighed the risk of not raising rates high enough against the potential impact of previous rate hikes that have yet to feed through. 

Ultimately, the members concluded that “there are increasing signs of some impact of higher monetary policy on the labour market and on momentum in the real economy more generally”. In other words, interest rates were already “restrictive” enough to justify a policy pause. 

Headline CPI is expected to see further significant falls over the months ahead, thanks to lower energy inflation and a further drop in food and core goods prices. 

Base effects will also do some of the heavy lifting. The impact of last year’s energy price surges will soon roll out of calculations, flattering annual inflation rates. But the impact will be short-lived: as we noted in September, Investec economist Ellie Henderson is among those warning that “the Bank will soon have to grow accustomed to not relying on energy prices to drag inflation lower” once base effects dissipate after the end of this month. 

Nevertheless, inflation will end the year far lower than it started – as the chart shows. The BoE expects CPI to fall to 5 per cent by the end of the year, hitting the 2 per cent target by early 2025. As ever, analyst forecasts are more variable, but many now think inflation could fall below the 5 per cent mark by the turn of the year.

This is good news for the government, which set itself the target of halving price growth by December 2023 – despite the task largely being out of its control. Given that the rate of inflation was 10.7 per cent in December last year, anything around 5 per cent would represent success. What looked unlikely earlier in the summer now seems very doable. 

But it is worth stressing that even if the rate of inflation falls to this level, prices will still be rising, just at a slower rate. A rough calculation reveals that even if the government meets its target, prices will have risen by 17 per cent over the past two years in the UK. 

Are rate hikes taking longer to feed through?

Inflation confounded policymakers and economists on the way up, and it is very hard to predict how a period of disinflation will impact the wider economy. Even though the picture looks clearer, some huge uncertainties remain.

Economists think that an increase in interest rates takes between 18 and 24 months to fully ‘transmit’ to the economy. This is a hefty time lag: two years ago, interest rates were still at 0.1 per cent, while 18 months ago, they had risen to just 0.75 per cent.

Policymakers think that the impact of higher rates is starting to squeeze the economy, but it wasn't until last month they were confident enough to hold rates steady – 21 months after the first hike. It raises an interesting question – is policy taking longer to make itself felt on this occasion?

The higher proportion of fixed-rate borrowing – particularly mortgages – has shielded the economy to some extent. In the UK, only around half of outstanding mortgage holders have seen their repayments increase, while the rest have been protected by deals fixed when interest rates were lower. Given that fixed-rate deals will eventually expire, there is a lot of tightening yet to come down the monetary policy pipeline.

When will the Bank of England cut? 

Soon, policymakers will face the same dilemma but in reverse. Many analysts expect that we won’t see rate cuts until the second half of next year, and this tallies with comments made by the BoE’s chief economist. Huw Pill memorably said that he would prefer a ‘Table Mountain’ profile for interest rates, rather than a ‘Matterhorn’. This was taken to imply a sustained period of 5.25 per cent interest rates, rather than a sharper rise and fall.

The median analyst forecast compiled by FactSet has the base rate falling to 4.5 per cent by the end of next year, and to 3.25 per cent by the end of 2025. But cuts are unlikely to begin until later on next year. And as we discussed last month, Capital Economics analysts think that once policymakers believe that inflation is under control, they may need to cut rates “quicker and further than investors expect” to stop inflation from falling below the 2 per cent target. Here, the impact of time lags will weigh on rate-setters again – any loosening will also take months to transmit to the real economy. 

Will lower inflation mean a higher unemployment rate? 

Forecasters today expect unemployment to rise as inflation falls – but not as much as history or economic theory would suggest. 

The BoE thinks that unemployment will rise from 4.3 per cent today to 5 per cent by the end of 2025 – equivalent to around 350,000 lost jobs. Though acutely unpleasant, this is a far smaller impact than we might expect. In the 1990s, high inflation was only quashed at the cost of a 10 per cent unemployment rate. Is today’s seemingly better trade-off just wishful thinking?

There are grounds for optimism. The Phillips curve (which sets out that there is an inverse relationship between inflation and unemployment), is beloved of economics textbooks but long-criticised by economists. Meanwhile, analysts point out that the pandemic’s labour market legacy could make things different this time. TS Lombard economist Dario Perkins argued earlier this year that the disruption of the pandemic made it hard to entice workers back to jobs they no longer wanted to do. This means that central banks might just be able to rebalance labour markets by destroying unfilled vacancies – rather than actual jobs. 

Could energy prices cause a second peak? 

Given the recent rise in oil prices, concerns are mounting that energy prices could push inflation up again. Matters are not helped by a rash of eye-catching comparisons to the 1970s (see chart), which also saw a second wave of inflation driven by an energy price surge. 

So far, at least, economists don’t see much cause for alarm. Analysts expect petrol price inflation to add just 0.2 percentage points to October and September inflation data, which should be more than offset by the impact of the fall in the Ofgem utility price cap.

What’s more, the mechanics of inflation calculations would make it hard to see another surge. UK energy prices are still roughly double their 2021 levels, and given this higher base, even a substantial absolute increase would translate to a lower annual rate of change. Economists at Dutch bank ING note that “even if we saw another 2022-style shock to wholesale prices, arithmetically, the scope for a similar shock to inflation at this point is more limited”. As a result, it would probably take a very sustained period of higher energy prices to trigger a change of course from central banks.