18 January 2023
The drop in inflation to 10.5% in December firmly establishes that inflation is on its way down. How quickly headline inflation falls will largely depend on whether energy prices stay at their current levels or rebound. If they stay where they are now, inflation may be a full percentage point (ppt) lower by the end of the year.
However, falling inflation doesn’t mean the end of interest rate hikes. Core inflation, which excludes volatile food and energy prices, is proving sticky and the labour market remains extremely tight. It will be touch and go as to whether the Monetary Policy Committee (MPC) will opt for a 25 basis point (bps) rise or a 50bps in February. But, the risk is that stickier wages and a shallower recession mean that interest rates will have to go higher than the 4.25% we currently expect.
Core inflation proving sticky
The main driver of the fall in the annual rate of inflation was a sharp drop in fuel prices, which decreased by 4.9% at the end of 2022, compared with no change at the end of 2021.
Of more interest to the MPC will be core inflation, which excludes volatile food and energy prices and was steady at 6.3%. This reflected two conflicting changes. Core goods inflation eased further to 5.8%, from 6.3%, driven by cooling pressure in the clothing and recreational goods categories. That probably reflects a surge in demand, the supply disruptions after the pandemic unwinding, as well as firms discounting excess inventory.
The downward move in core goods was offset by a spike in services inflation, which rose to 6.8% from 6.3%. Admittedly, the acceleration partly reflected a spike in airfare prices, which can be extremely volatile. But the broader point is that the evolution of services prices are closely linked to the domestic economy. So, the fact that services inflation is running miles above the 3.3% average for 2000-19 will be of concern to the MPC.
The good news, though, is that pipeline pressures eased for the sixth straight month in December. Inputs price inflation, measured by the Producer Price Index, fell to 19.5% in December from a prior reading of 20.9%.
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 4% by the end of the year.
The big unknown is the path for energy prices. If energy prices stay around their current lows, then the 20% increase in energy bills scheduled for April may be cancelled and energy bills could even start to be cut later this year. This could mean inflation is at least 1 ppt lower by the end of this year than we currently expect.
The policy takeaway
Sticky core inflation, combined with a still red-hot labour market, makes it more likely that the MPC will raise interest rates by 50bps in February. Looking further ahead, we think interest rates are nearing their peak. Rates are already well into restrictive territory and it’s the level of borrowing costs not the pace of change that matters for the policy stance.
We 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, requiring a response from the central bank.