15 November 2023
The huge leap down in inflation in October, from 6.7% to 4.6%, was mainly driven by the jump in energy prices last year falling out of the annual comparison. However, inflation was weaker across the board. Encouragingly food price inflation, which has been stubborn, cooled significantly.
More importantly for the Monetary Policy Committee’s (MPC) core and services inflation, which strip out volatile food and energy prices, also fell sharply and both came in lower-than-expected. This is unambiguously positive news for the broader economy and justifies the MPCs decision to keep interest rates on hold at 5.25%. Indeed, inflation is now 0.3 percentage points (ppts) below the forecast the MPC made in August.
The sharp drop in inflation will also be important for the labour market. Real wage growth will pick up sharply in October, which should help the economy to avoid a recession at the end of the year. The sharp fall in October should also help to anchor inflation expectations slow nominal wage growth, reducing one of the key risks for the MPC.
Inflation will probably hover around current levels for the rest of the year before taking another leg down in the first half of next year. However, the second half of the journey down inflation mountain will be tougher. Inflation probably won’t get back to something starting with a 2 before the second half of next year and will require interest rates to remain in restrictive territory for a while yet, that’s why we don’t expect interest rates to start to be cut until Q3 next year.
Energy prices drive down inflation
Energy price inflation dropped from +4.5% year-on-year (y/y) in September to -21.7% in October as the big rise in energy prices last year dropped out of the annual comparison. There was also an easing of inflationary pressure in the core goods category, which dropped back to 4.3% from 4.7%. Food also weighed, slowing to 10.1% year on year from 12.3%.
Importantly for the Bank of England (BoE), services inflation dropped to 6.6% from 6.9%. We estimate the BoE’s measure of core services, which strips out airfares, education and package holidays, cooled to 6.6% in October, from 7% previously.
Looking ahead, the headline rate of CPI inflation likely will remain around current levels for the rest of the year.
What’s more, October’s 4.1% rate of food producer output price inflation points to clear scope for food CPI inflation to fall further from October’s 10.1% rate. Similarly, October’s 0.2% rate of core producer output price inflation signals a further decline in core goods CPI inflation, which dropped to 4.3% in October, from 4.7% in September. Growth in services’ firms costs also looks set to slow. While energy bills for some businesses will jump if they have a long-term fixed-price deal with a supplier that is due to expire, others will see their bills come down if they locked-in last year for only 12 months.
The next leg down in inflation will come in the first half of next year. However, it will probably be the second half of 2024 before inflation gets back below 3%.
The policy takeaway
The MPC will take today’s data as justification for leaving interest rates at 5.25%. That should be enough to put to bed any lingering speculation that the MPC will have to resume hiking rates.
However, the economy is defying gravity, the labour market is cooling only slowly and while both pay growth and services inflation have fallen, they remain a long way from the levels that might be expected to prevail in a world of 2% inflation.
As a result, interest rates are likely to stay high for an extended period. We don’t expect interest rates to be cut until Q3 next year and even then, cuts will be gradual.