Inflation temporary drop before Budget measures take effect

Inflation slowed faster than expected in February to 2.8%. It was welcome news for the Bank of England (BoE) and the Chancellor, Rachel Reeves, before her Spring Statement on Wednesday. 

However, it’s likely to be a temporary slowdown before prices rise again in April when administered prices – those set by regulators – and Autumn Budget tax rises take effect. 

Our view is that inflation is likely to peak at close to 4% later this year, but there is a risk that firms pass rising employment costs on to consumers more aggressively. If that happens, then it’s difficult to see how the Monetary Policy Committee (MPC) can afford to cut interest rates three times, as expected.

What is driving inflation?

The fall in inflation to 2.8% was exactly what the Bank of England had forecast. The drop was driven by a slowdown in goods inflation to 0.8% from 1%, primarily because of clothing inflation. This fell to -0.6% from 1.8% as retailers offered more discounts than usual in the face of weak demand.

Tobacco and alcohol prices also added upward pressure, jumping 1% in February alone to put annual inflation at 5.7%, up from 4.9% in January. That was driven by alcohol duties on non-draught products coming into effect on 1 February.

Core inflation, which excludes volatile components such as energy and food, dropped to 3.5% from 3.7% as housing and furniture price pressures eased slightly.

What’s the UK inflation outlook for the rest of 2025?

Despite today’s fall, we still expect a material increase in inflation over the coming months. We foresee a big rise in April before inflation peaks later in the summer. There are a couple of reasons for this.

First, April means higher taxes. Increased Employer National Insurance Contributions (NICS) will boost prices as firms try to recover some of the cost. This will be more evident in the short-term because it is far easier for firms to pass the cost on through prices than slower wage growth, which takes time.

What’s more, the reforms impact low-paid sectors the most, such as hospitality and retail, where the National Living Wage (payable to people aged over 21) is increasing 6.7%, removing the possibility of passing that cost on through wages completely.

Second, April will mean a swathe of administered prices increase, such as the energy price cap, pushing the headline rate up. Many of these regulated prices are based on older, and therefore higher, inflation figures. This likely won’t worry the Bank of England too much, as they’ll largely be viewed as one-off shocks.

In addition, if the US administration implements reciprocal tariffs on the world economy next week, then that could prompt a global trade war, which would see inflation head higher over the year. 

The policy takeaway

While the drop in headline inflation is good news for the BoE, it’s unlikely to make much difference to the interest rate outlook for a few reasons.

First, services inflation held steady at 5%. That measure is particularly important to the MPC because it is more reflective of domestic price pressures than goods inflation. The BoE had pencilled in 5.1%, so while that should keep a May rate-cut on the cards, the MPC will want to see a more material easing first. 

Second, the MPC will be much more concerned with how inflation looks after April. This is when we’ll start to get an idea of just how much firms will past the cost on to consumers in the form of higher prices. If that surprises to the upside, then the Bank may have to slow cuts. 

Finally, the BoE’s more hawkish tone this month emphasised worries around inflation expectations. If pay growth remains persistent, or even rises, off the back of the coming increase in inflation, then that could have a secondary effect on inflation as stronger consumption feeds through to higher prices. 

Ultimately, our base case is still for the BoE to continue cutting rates approximately once a quarter. However, the risks are clearly growing that the MPC stops its easing cycle early and keeps interest rates above 4% to squeeze out any lingering price pressures. 

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