Inflation above target until 2027, but won't stop rate cuts

Consumer Price Index (CPI) inflation jumped to 3.5% in April, where we expect it to stay until next year. In fact, we don’t anticipate inflation returning to the Bank of England’s (BoE) 2% target until 2027. With energy prices, one-off regulated price increases and erratics such as airfares contributing to April’s inflation figure, the BoE will try to look through these as much as possible. Given the wider underlying trends, we still therefore expect two more interest rate cuts this year. 

What fuelled April’s inflation?

We expected the big jump in April’s inflation data, which was primarily driven by two major factors. 

First, energy price inflation. This was 6.7% y/y in April, up from -10.1% in March. It added a whopping 56bps to the headline measure and accounted for over half of the large increase from the 2.6% headline rate in March. This swing was partially driven by a base effect because the 12% fall last April came into the annual comparison. 

Second, the price of water supply and sewerage services rose by over 25% as the regulator approved a sizeable increase in charges. This added a further 18bps to the headline measure. 

Together with energy prices, these two factors explain around 80% of the increase in inflation. 

The timing of Easter also impacted April’s data. It meant airfares, which are often erratic, rose by 27.5%m/m, alongside a smaller price rise in package holidays. Together, these added a further 16bps to inflation. This helps to explain some of the surprising jump in services inflation from 4.7% to 5.4% in the year to April. It should provide at least a little comfort to the BoE given the rise was partially driven by fluctuating seasonal factors that should weaken in May. 

That said, oil prices, which have been falling off the back of Trump’s tariff turmoil, helped to soften the month’s rise slightly as fuel price inflation fell further to -9.3% from -5.4%. 

The surprise in April’s data is that there isn’t much evidence firms have passed on the increase in employment costs through a sizeable increase in prices. In fact, hospitality inflation fell to 2.7% from 3%. Clothing and footwear inflation also turned negative at -0.4% from 1.1% in March. Food inflation ticked up, which could be due to the rise in employment costs, but on the whole we see little evidence that firms raised prices significantly in April. 

The UK’s inflation outlook

We forecast that April’s jump in inflation is the start of a prolonged period of 3%+ inflation before it drops back closer to 2.5% by April 2026.

While some volatile components like airfares will unwind in May, which should put some downwards pressure on inflation, we expect inflation to hover around 3.5% for the rest of the year and even come closer to 4% at times.

The big risk is that April was just the beginning of firms adjusting to higher taxes and employment costs. While there was limited evidence of firms passing through higher costs, with most of the rise being explained by regulated price increases and erratics, this suggests there is still scope for firms to try and drip-feed price rises across the rest of the year. Ultimately, we see the disinflationary process as still on track, despite April’s figures making for a painful read and we don’t see inflation returning to target until 2027. 

Implications for the Monetary Policy Committee (MPC)

We doubt that April’s reading will change the MPC’s thinking, despite BoE Governor Andrew Bailey once again needing to pen his letter to the Chancellor explaining why inflation has moved away from target. 

The BoE had forecast inflation to hit 3.4% in April, so the 3.5% reading was still broadly in line with its forecast. While it expects inflation to peak at 3.7% in September, underlying inflation should continue to ease. 

That said, a rift had clearly started to open among MPC members at the last meeting. Two members voted for a bumper 50bps cut while another two voted to hold. Those more dovish members see the rise in inflation as a one-off and want to ease policy to support sluggish growth.

Meanwhile, the hawks are concerned that another period of above-target inflation will prompt workers to continue bargaining for above-inflation pay increases to protect their real incomes, which would also force firms to raise prices even more. 

Indeed, the BoE’s Chief Economist and MPC member, Huw Pill, has recently argued that firms and employees have been far more aggressive at trying to protect their margins and real incomes in recent years, which has slowed the disinflation process. 

We think that’s unsurprising given inflation will have been above the 2% target for five years by the end of 2025 if the current bout of inflation persists as we expect. This structural shift increases the likelihood that pay growth remains sticky, despite a cooler labour market, and firms keep raising prices to protect their margins. In that scenario, the MPC would need to keep interest rates more restrictive and may only be able to cut once more this year. 

Ultimately, the MPC will need to remain vigilant against a backdrop of above-target inflation and strong wage growth, but the underlying disinflationary process remains intact. Hence, we still expect the MPC to cut twice more this year, leaving interest rates at 3.75%. 

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