CPI inflation: Inflation undershoot keeps rate hope cuts alive

22 February 2024

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, which would throw the door wide open to an interest rate cut in the spring or early summer. 

Key drivers 

The slowing trend in consumer price rises remains intact, despite the stable headline rate of CPI inflation in January. As expected, the contribution from electricity and natural gas prices to the headline rate increased by 0.3 percentage points (ppts) in January, driven by an increase in Ofgem’s price cap, which will be short-lived. By contrast, food CPI inflation dropped to 6.9%, from 8.0% in December, while non-energy industrial goods CPI inflation declined to 2.7%, from 3.1%, moving further in line with producer prices. Meanwhile, the slight rise in services CPI inflation was entirely due to a base effect; prices for catering services fell very sharply in January 2023, only then to soar in February.

What next?

Looking ahead, it remains likely that the headline rate of CPI inflation will fall back to about 2.0% in April and then modestly undershoot the 2% target over the following six months. Ofgem will likely announce on 23 February that it will reduce its energy price cap by about 15% in April. On the basis of the new, slightly smaller weights for the energy components in the CPI, this price decline will have a -0.6% impact on the month-to-month change in the all-items index in April. 

In addition, we think the Government will find the funds in the forthcoming Budget to freeze fuel duty at its current level in April. Meanwhile, food CPI inflation will converge towards January’s modest 0.5% rate of producer output price inflation over the next six months, as the anniversary of chunky price rises in early 2023 is reached. Similarly, January’s -0.4% rate of core producer output price inflation points to further scope for core goods CPI inflation to decline. 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 Monetary Policy Committee (MPC) has referenced two measures of underlying services prices in the past, and near-term momentum in both has slowed. Its long-standing measure, which excludes airline fares, education and package holidays, rose by just 1.2% on a seasonally adjusted month-to-month annualised basis, according to our calculations. Three-month-on-three-month growth in this measure slowed to 4.1%—its lowest rate since February 2022—from 4.6% in December. 

In addition, the MPC's new measure, which excludes accommodation services, airline fares and non-private rents, rose by 4.3% on a seasonally adjusted month-to-month annualised basis, slowing from December’s 4.8% pace. Three-month-on-three-month growth in this measure eased to 4.9%, from 5.6% in December. Accordingly, services CPI inflation will fall further over the coming months, if the recent rate of price rises is sustained.

One potential hazard is the upcoming Budget. A debt funded tax cutting spree could give a boost to aggregate demand, which while good for consumer spending, could also raise concerns about inflation and wages, prompting the MPC to reassess the need for interest rate cuts. 

That path of headline inflation will make it hard for the Bank of England to maintain the current level of policy restrictiveness. Our baseline is for a first cut in May. However, the risk is that the first move is delayed to June. At that point, the MPC is likely to have two sub -2% CPI prints in hand as well as hard data on the impact of the near 10% rise in the National Living Wage on the pay distribution.