20 July 2022
Another above-expectations rise in inflation to 9.4% means prices are still rising at the fastest rate in more than 40 years. Pressure is now on the Monetary Policy Committee to raise interest rates by a more aggressive 50 basis points (bps) at its next meeting in August – especially as there is plenty of evidence that inflation is becoming more broad-based. We can expect interest rates to reach 2.25% by the end of the year.
What’s more, inflation has further to go. It may rise above 11% in October when Ofgem increases its energy price cap again (current market pricing suggests another 40% to 50%), and as food price rises continue to filter through. This will leave annual inflation at more than 8%, its highest rate since the early 1980s.
However, inflation should fall sharply in the second half of 2023 as the recent rises in energy prices fall out of the annual comparison. This, combined with a much weaker economy over the rest of the year, may be enough to let the MPC press pause on its tightening cycle in early 2023.
More signs inflation is broadening
The rise in inflation from 9.1% in May to 9.4% in June was mainly driven by a large jump in fuel price inflation, which went from 32.8% in May to 42.3% June. The good news, though, is that the 15% fall in oil prices over the last month is consistent with petrol prices dropping by about 10 pence a litre over the next couple of months.
Food and drink inflation was also a major contributor, rising from 8.6% in May to 9.8% in June. Food price inflation is likely to peak at around 12% later this year.
But food and fuel is just part of the inflation story. Admittedly, core inflation ticked down as the surge in prices of goods impacted by the pandemic began to unwind. Second-hand car inflation dropped from 23.4% in May to 15.2% in June. But total goods inflation rose from 12.4% in May to 12.7% in June. But services inflation rose to 5.2% in June, from 4.9% in May; the fifth consecutive rise, and the highest rate since 1993.
Inflation in this category is more closely linked to the evolution of the domestic economy, particularly the labour market. It also tends to be more persistent. The latest reading is well above the average of 3.3% seen between 2000 and 2019. This indicates a sector facing ongoing challenges, including finding enough labour to deal with the return of consumers who’ve become less cautious about the risk of coronavirus.
Pipeline pressures remain elevated, after already shaken supply chains were further rattled by the war in Ukraine and China’s extended lockdowns. Input prices rose by 24% on the year.
The really bad news is that we think there is even worse to come:
- food price inflation will continue to climb over the rest of the year, potentially hitting 12%;
- Ofgem seems set to lift the energy price cap by another 50% in October. This will keep inflation high and push it above 11% in October.
After that, much will depend on how Russia’s invasion of Ukraine impacts energy costs. As things stand, gas and electricity prices have dropped back significantly from the highs seen in early March, but remain well above their pre-pandemic levels. And there is a significant risk of another surge in prices if Russia cuts off supplies of natural gas.
All of that said, inflation should fall sharply in the second half of 2023 as the recent rises in energy prices fall out of the annual comparison. We could see inflation back to around 3% by the end of 2023, and down to 2% in early 2024.
The policy takeaway
The rise in inflation, combined with an extremely tight labour market, ensures another interest rate rise in August. The big question is whether that rise will be 25bps or 50bps. Remember that the MPC signalled it might move in bigger steps than 25bps when it said that signs of more persistent inflationary pressure would be met by ‘forceful action.’
We think the jump in inflation to 9.4% and rising services inflation meets the threshold for more ‘forceful action.’ Combine this with the more resilient economy and surge in jobs over the last month, and it looks like it will be enough to convince most MPC members to vote for a 50bps hike in August.
The huge rise in inflation will mean there is likely to be very little growth in GDP in the second half of the year. In fact, our forecasts suggest average GDP growth will be flat in the last three quarters of this year (growth is likely to be very bumpy over the next year) – so while we aren’t forecasting a recession at the minute, the UK could easily be pushed into one by a slight upward shift in oil prices or a small disruption in supply chains. The MPC may therefore pause its tightening cycle in early 2023.