22 June 2022
Prices are rising at the fastest rate in more than thirty years. The jump in inflation to 7% will pile pressure on the Monetary Policy Committee (MPC) to raise interest rates again at its next meeting on 5 May – and that won’t be the end of it.
Inflation has much further to rise. We think it will peak at 8.5% in April due to the 54% increase in Ofgem’s energy price cap, but a reading of up to 9% is possible. And there is likely to be a second peak of around 8% in October if Ofgem revises the energy price cap up again. This will leave inflation above 6% at the end of the year and annual inflation at around 7.5%, its highest rate since 1991.
The rise in inflation from 6.2% in February to 7% in March (consensus 6.7%) was broad-based, with prices rising rapidly in almost every major category. As expected, the 9.9% m/m surge in fuel prices in March was the largest monthly rise on record and lifted fuel inflation from 22.3% to 30.7%. Food and drink inflation also rose from 5.1% to 5.9%, the highest rate since September 2011. And the surge in agricultural prices triggered by the war in Ukraine means we expect food inflation to reach 7% soon.
More generally, goods inflation continued to rise rapidly, jumping from 8.3% to 9.4%. But inflation across the services sector, which is a better measure of domestically generated inflation and had been relatively steady for the last five months, also rose strongly, going from 3.5% to 4.0%. Core inflation, which excludes, energy, food, alcohol and tobacco, rose from 5.2% to 5.7%. As a result, it is abundantly clear that recent surges in energy and imported goods inflation are feeding through into higher inflation in the rest of the economy.
Inflation will spike again in April as the 54% rise in the energy price cap, set by industry regulator Ofgem, takes effect. We expect inflation to hit 8.5%, but a reading of up to 9% can’t be ruled out given the run of above-expectation surprises.
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. If wholesale costs remain steady from here, the price cap would jump by slightly more than 30% in October, leaving annual CPI averaging about 7.5% in the last quarter.
The policy takeaway
The Bank of England delivered a dovish hike at its March meeting, signalling it was increasingly concerned about the prospect of a squeeze on spending power hitting demand in the economy. However, the combination of a strong labour market and rapidly rising inflation probably seals the deal for a 0.25% interest rate hike in May.
Our current base case is that the MPC pauses in the second half of the year, as inflation concerns give way to worries about the growth outlook against the backdrop of a serious cost-of-living crisis.
Of course, the outlook for monetary policy largely depends on the situation in Ukraine and how energy prices respond. But with inflation again running well ahead of expectations, there’s a growing risk that the MPC signals in May that it intends to keep lifting interest rates throughout the year in order try to prevent higher inflation becoming entrenched. Indeed, financial markets are still expecting rates to reach 2% by the end of this year.