CPI inflation: Big fall in inflation raises chances of an early MPC pause

15 February 2023

The big drop in inflation to 10.1%, from 10.5% in December, is encouraging. But the more important news is the large drops in core and services inflation. The Bank of England (BoE) cares much more about services inflation, as it is much more closely related to the domestic economy than the headline rate of inflation. 

At its last meeting the Bank implied that if the economy evolved in line with its forecasts, then it probably wouldn’t need to raise interest rates again. Given today’s CPI print was bang in line with the BOE’s latest forecast, it’s now likely that 4.0% will be the peak in interest rates. 

However, the Bank is also watching the labour market exceptionally closely, which came in a little hotter than expected. We think that makes it one-all for hold or raise in March. It’s now a 50-50 call.

Weaker across the board

The main driver behind the annual rate’s decline was a sharp drop in transportation prices. Fuel costs decreased by 3.8% in January 2023, compared with a drop of 0.5% at the start of 2022. Airfares also pushed down, falling 41.7% versus a 29.1% slide in January last year. Food price inflation ticked down by 0.1%, indicating that perhaps even food inflation has now peaked.

Meanwhile core inflation, which excludes volatile components like food and energy, fell sharply to 5.8% from 6.3% in December. The print reflected an easing in core goods inflation, which fell to 5.6% from 5.8%, and lower services inflation.

What’s more, the Monetary Policy Committee’s (MPC) preferred measure of services CPI inflation—which excludes airline fares, package holidays and education from the main services index, as well as the estimated direct impact of VAT changes—fell to 6.0% in January, from 6.5% in December, undershooting the MPC’s 6.7% forecast it made earlier this month. 

In addition to this, pipeline pressures eased for the seventh straight month in January. Input price inflation, measured by the Producer Price Index, fell to 14.1% in January from a prior reading of 16.2%. This should feed through into lower goods prices over the next few months. 

What next? 

Inflation will continue to fall over the rest of this year. It will likely reach 9% in March, as the fall in commodity prices and shipping costs over the last six months works its way through to prices for food and core goods, and reach around 2% by the end of the year. 

Wholesale prices suggest that the CPI inflation rates for electricity and natural gas will slump to about -10% by the end of the year, from their 65% and 129% rates in January. The stabilisation of global agricultural commodity prices over the last six months suggests that food CPI inflation will fall to about 2.5% by the end of this year, from 16.7% in January.

The policy takeaway 

The Bank’s latest guidance, published earlier this month, suggested that rates only need to go higher if services inflation and wage growth remains strong.

So far, the evidence is mixed. Private sector pay growth in the latest labour market release was buoyant enough to warrant further tightening, but the big undershoot of services inflation in January’s CPI data strengthens the case for a pause.

Still, there is a lot of data to be published between now and the Bank’s decision next month on 23 March. The downside surprise in services inflation will need to be backed up again next month, while pay growth will need to show clear signs of cooling.

As such, we still expect rates to peak at 4.25%. But the risk is that rates go a little higher. The decline in natural gas prices in recent weeks means the squeeze on consumers this year is unlikely to be as intense as initially feared. That will likely mean both demand and underlying inflation are stronger, potentially requiring a response from the central bank.