What is contributing the most to UK inflation?
Sources: Reproduced from Bank of England Monetary Policy Report, August 2023, Chart 2.2 and Investec
Energy and other goods drove inflation higher in 2022. Overall, inflation is coming down, but it remains too high. The Consumer Price Index (CPI) measure peaked at 11.1% in October 2022, while its current reading of 6.8% (July 2023) is still well above the 2% target. Last year's big story was the dramatic surge in energy prices, particularly for electricity and gas. But these are now falling, which is helping to push inflation down. Food price inflation, close to 20% in the spring, has also started to ease.
There is relatively little that the Bank of England can do in the face of these sorts of price pressures; interest rates cannot influence the cost of bananas, for example. Its main job is to guide inflation lower by containing the spread of price pressures elsewhere in the economy. This is easier said than done. Most importantly, services inflation is currently running at a three-decade high of 7.4% and is now the single biggest contributor towards CPI inflation overall.
What is the predicted level of inflation following interest rate rises?
Note: Quarterly forecasts based on market expectations of interest rates. Sources: ONS monthly outturn data up to July 2023, then quarterly forecasts from Bank of England, Monetary Policy Reports, August 2023
The Bank of England’s forecasts do show inflation fading towards the target level of 2% over the next two to three years (as do forecasts from Investec) but for this to be realised, a significant turnaround in the service sector will be required. Services inflation often proves 'stickier' as it is linked to pay growth which, in part, is being supported by the current tightness of the labour market. Conditions in the labour market do appear to be loosening recently however, with unemployment increasing and vacancies declining.
On current trends it seems likely that inflation is broadly on track to meet the target, but the continued strength of pay poses a risk to this. This state of play suggests strongly that the Bank of England is on course to lift the Bank rate by a further 0.25% to 5.50% to counter these risks, at the next MPC meeting on 21 September 2023.
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