22 June 2022
The tick up in inflation to 9.1% means prices are rising at their fastest rate in more than 40 years. This will pile pressure on the Monetary Policy Committee (MPC) to raise interest rates by a more aggressive 50 basis points (bps) at its August meeting. We expect interest rates to reach 2% by the end of the year.
What’s more, inflation has further to go. It may hit 10.5% in October, when Ofgem increases its energy price cap again 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 at the start of 2023.
More signs inflation is broadening
The rise in inflation from 9% in April to 9.1% in May was mainly driven by a large jump in food and drink inflation, which went from 6.7% in April to 8.6% in May. Food price inflation will continue to rise over the rest of the year, probably hitting 10% later this year.
The cost of filling up at the pump rose by 2.3% on the month. There is likely to be an enormous leap in fuel prices in the June CPI figures – we currently see a rise of 9% – as the effect of rising oil prices is passed on to consumers. Oil prices have fallen by 10% over the last two weeks, however, and that should feed into lower fuel inflation later in the summer.
Food and fuel is just part of the inflation story. Total goods inflation remained steady at 12.4%, the first time it hasn’t risen since July 2021. But services inflation rose to 4.9% in May, from 4.7% in April, the fourth consecutive rise and 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 22.1% on the year.
The really bad news is that we think there is even worse to come:
- lockdowns in China are likely to drive up goods and shipping prices again;
- food price inflation will continue to climb over the rest of the year, potentially hitting 10%;
- Ofgem will probably lift the energy price cap by another 30% or 40% in October. This will keep inflation high and push it to 10.5% 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-crisis levels.
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 think inflation will probably be back to around 3% by the end of 2023 and 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.’
Today’s release will neither confirm nor deny whether the threshold for more forceful action has been met. Indeed, it is not obvious to us that there are signs of the ‘more persistent inflationary pressures’ that would prompt more forceful action. As such, we are sticking with our base case of three more 25bps rises over the rest of this year, taking interest rates to 2%.
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 once rates reach 2%.