Inflation a welcome drop but it will not last

Inflation surprised again in March, slowing to 2.6%, which was slightly below our forecast of 2.7%. It’s welcome news for the Bank of England (BoE) and makes a May interest rate cut all but guaranteed. 

However, this latest inflation slowdown will be short-lived. April’s reading will be the first to include the Autumn Budget’s tax hikes and some punchy rises in administered prices. This points to inflation likely peaking at around 3.7% by September. That said, the impact of tariffs could cause a global slowdown. In this scenario, inflation fades quicker, assuming we don’t get embroiled in an escalating tit-for-tat trade war.

What is driving inflation?

The fall to 2.6% was broad-based with most categories putting downwards pressure on the measure.

Goods inflation dropped down to 0.6% and services inflation dropped to 4.7%. Services inflation has been a big concern for the BoE, so this drop will make a rate cut in May even more likely.

Transport inflation eased to just 1.2% as fuel prices dropped on the back of a fall in oil prices amid the tariff chaos. Motor fuels have now declined by 5.3% in the year to March. Recreation and culture exerted even greater downwards pressure and a small fall in food prices to 3% from 3.3% is also positive news for consumers.

Clothing bucked the trend, rising to 1.1% from a drop of 0.6% in the 12-month rate in February. It suggests demand recovered thanks to a dryer than usual March after an unusual fall in February where retailers continued to discount more than usual.

The UK’s inflation outlook

Despite today’s figures, inflation will pick up sharply in April for three key reasons.

First, we expect energy prices to tick back up again with the Ofgem price cap rising by 6.4% in April. We estimate the rise in gas and electricity will add around 0.3ppts to the headline rate alone. 

That said, the rise in inflation could remain weaker than expected if the current tariff-induced recession fears keep oil prices depressed in the near-term. Assuming oil prices remain around current levels and exchange rates remain stable, this could knock roughly 0.5ppts off the headline rate. Looking further ahead, if tariffs weigh on growth and we witness a global slowdown, then that will exert a downwards pressure on inflation and a deflationary effect, but this would take longer to feed through than lower oil prices.

Second, April’s reading will be the first to include the Budget’s tax rises. The big rise is Employer National Insurance Contributions (NICs) going from 13.8% to 15% while the threshold firms start paying is lowered to £5,000. 

Part of this adjustment will come through slower wage growth, but that will take time. For now, firms will adjust by raising prices and trimming headcounts. The BoE’s decision-maker panel suggests around 60% of firms intend to raise prices. If firms do this more aggressively than expected, then inflation could surprise to the upside. 

However, the 6.7% rise in the National Living Wage (NLW) and even larger rises in the National Minimum Wage (NMW) in April will remove the slower wage growth avenue for hospitality and retail employers. At an aggregate level, the combination of increased employer NICs and NLW/NMW will add around 2ppts to employment costs. 

Third, April will see regulated prices increase. This shouldn’t stop the Monetary Policy Committee (MPC) from cutting interest rates, as these rises are viewed as one-offs and not a direct result of current inflationary pressures. Instead, they are based on older figures when inflation was far higher.

The policy takeaway

March’s inflation drop makes a May rate cut almost certain. Especially after a decent fall in services inflation, which is more reflective of domestically generated price pressures.

However, the MPC did strike a more hawkish tone at its last meeting, suggesting it was hesitant about its “gradual and careful” path. It reflected concerns about firms passing on higher employment costs, stubborn services inflation and worries that the coming rise in inflation would have second-round effects. This is where anticipated inflation remains elevated, with surveys suggesting pay expectations are stuck around 4%, which could feed through into further inflation.

That said, since the chaos of the US administration’s “reciprocal” tariffs announcements, the combination of significantly lower oil prices combined with weaker growth due to the uncertainty and slowdown in global demand could mean the rise in inflation is much more subdued.

Assuming the UK doesn’t retaliate, it looks like tariffs will be more deflationary, giving the BoE room to ease interest rates faster and support the economy. In fact, markets were more hawkish than our forecast at the start of April, but are now leaning towards rates ending the year at 3.5% instead of the 3.75% we forecast.

Our base case is still for a rate cut at every other meeting this year, but the risks have sharply increased so the MPC might be forced to ease policy more quickly. If the BoE goes down this route, then consecutive rate cuts seem more likely than a big 50bps move in May.

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