CPI inflation: 2% in sight, but we’ll have to wait for rate cuts

Inflation in the UK economy is clearly easing much more quickly than expected and the surge in prices of the pandemic and energy crisis will soon be a bad memory. We still expect inflation to fall below 2% as early as April and then to spend most of this year below the target. That should provide all the cover the Monetary Policy Committee (MPC) needs to start cutting interest rates in the early summer.

Key drivers 

Inflation dropped from 4.0% to 3.4% in February compared to expectations of a fall to 3.5%, continuing its streak of underperformance. The good news was that both core inflation, which excludes volatile components like food and energy, fell to 4.5% and services inflation, which is closely related to price pressures in the domestic economy, dropped to 6.1%. What’s more, elsewhere, the disinflationary momentum in food prices continues, slowing to 5% from 7%.

What next? 

Looking ahead, it remains likely that the headline rate of CPI inflation will continue to fall over the next few months. We expect it to be 3% in March then fall back to about 2.0% in April and then modestly undershoot the 2% target over the following six months. Ofgem will cut the energy price cap by 12% in April, food CPI inflation will continue converging to weaker producer output price inflation over the next six months as the anniversary of chunky price rises in early 2023 is reached.

The outlook for services CPI inflation remains less clear, given uncertainty about labour market tightness and the potential impact of April’s near -10% increase in the National Living Wage on overall labour costs. Nonetheless, services firms’ other costs are rising less quickly and energy bills will fall for most businesses when they renew their fixed-price deals with suppliers.

The policy takeaway 

The drop in headline inflation to below 2% will provide excellent cover for the MPC to pivot and start cutting interest rates early in the summer. What’s more, the sharp slowdown in headline inflation should add further impetus to the downward trend in pay growth. Underlying wage gains have cooled markedly in recent months. 

We doubt the 0.1 percentage point (ppt) undershoot in February will be enough to prompt the MPC to start talking about rate cuts in its meeting on Thursday, even though in our opinion that time has now come. Indeed, we think the MPC would be fully justified in implementing the first rate cut in March. However, fears about the labour market mean we will probably have to wait until the May meeting to see a significant change in tone and then until June to see the first actual cut in interest rates. But the big risk now is that the Bank holds interest rates in restrictive territory longer than is necessary, crimping economic recovery.

More broadly, sharply lower inflation from the spring will set the stage for an economic recovery in the second half of the year as stronger real wage growth, falling interest rates and tax cuts boost consumer spending and economic growth.