UK inflation and monetary policy: where to from here?

With inflation proving decidedly sticky, how is it likely to evolve from here and what are the monetary policy implications? Our Chief UK Economist takes a closer look.

The stickiness of core inflation is problematic, and at a time when the economy is flatlining poses a real conundrum for monetary policymakers. As recently as last month, core inflation was expected to have fallen to 5.7% in February, and presumably slightly more in March. Similarly, services inflation remained at 6.6% in March – almost twice its long-run average.

And it’s a similar story when it comes to wages. Headline three-month average weekly earnings (AWE) inflation came in at 5.9% year-on-year in February – well above the consensus forecast of 5.1%. While UK wage inflation can be rather volatile in the early part of the year, this is still an extraordinarily large overshoot.

In terms of the big picture, food and energy continue to make outsized contributions to UK inflation: while they account for a combined weight of slightly under a quarter of the CPI basket, they’re responsible for just over half of the current CPI inflation level of 10.1%. 

Inflation is likely to fall from here, but not quite as quickly as previously expected

We can now say with confidence that headline inflation has peaked. CPI inflation is forecast to fall sharply next month, down from 10.1% year-on-year in March to 8.0% in April. This is overwhelmingly due to ‘base effects’: domestic gas and electricity prices shot up by 47.5% last April following Russia’s invasion of Ukraine.  

By contrast, Core CPI inflation is expected to remain sticky, edging down from 6.2% to 6.1%, although the balance of risks around this forecast is by no means clear cut.

Domestic gas and electricity inflation will exert the strongest downward pressure on CPI inflation in April: we expect it to plummet from 85.6% in March to 25.6% in April. Food price inflation is forecast to edge down, again mainly due to base effects, from 19.1% year-on-year in March to 18.2% in April.

Looking further ahead, inflation in the UK looks set to drop dramatically as the energy shock from Russia’s invasion of Ukraine unwinds in the second half of this year. We forecast that headline CPI will fall to 3.5% by the end of 2023 (although previously we expected it to fall further – to 3.1%), and from there to edge down to around 2.5% by the end of 2024. We expect it to return to its 2% target around the middle of 2025. Our forecast for core CPI inflation is that it will fall to 4.2% by the end of this year, and to 2.1% by the end of 2024.

Wages are still rising

We continue to expect upwards pressure on wages to subside as a result of base effects (especially in the second half of the year), falling CPI inflation, and the wider effects of subdued economic growth – which is likely to result in reduced demand for labour. But on the flip side, the latest earnings figures are so high that we’ve raised our forecast for wage inflation.

We now forecast three-month AWE (not including bonuses) growth to stand at 4.8% year-on-year by the end of this year (with an average of 6.1% over the calendar year) and 3.2% by the end of 2024 (with an average of 3.4% over the year). Total AWE (in other words, wages including bonuses) is likely to be higher at around 5.5% at the end of 2023, although there’s inevitably more uncertainty about this figure as bonuses are inherently hard to predict.

The implication for monetary policy: a rate hike now looks more likely, but risks tipping the economy over the edge

Overall, while there’s a strong case for not raising the Bank Rate further – mainly due to the fact that around 80% of the policy tightening that’s been announced since December 2021 is yet to impact mortgage debt-servicing costs – we suspect the stronger-than-expected momentum in the wage inflation data will tip a still-jittery Monetary Policy Committee towards a 25 basis point hike in May. This is in contrast to our previous view; we expected no hike in May and the bank rate peaking at 4.25%.

As we discussed above, beyond that point – and ahead of the Bank of England’s subsequent round of forecasts in August – spot inflation should be falling much more sharply, affording the Monetary Policy Committee some greater leeway.

It's possible that rate hikes beyond 4.5% will be required, but monetary policy already appears to be in restrictive territory (once low fixed-rate mortgage deals expire), and the Bank of England has previously indicated that policy rates of around 5.25% would risk an unnecessarily severe recession.

Still, that a flatlining economy (with economic growth merely back to pre-pandemic levels) may require policy rates around 5% in order to return inflation to its 2% target is a cause for considerable concern. 

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