Higher inflation, higher interest rates and higher government borrowing costs – is rip-off Britain back? The good news is that this is mostly due to the UK’s policy choices. The bad news is that changing those policies looks difficult.

UK inflation has more than doubled in less than a year (see chart), from 1.7% in September to 3.8% in the latest figures (for July). Over this same period, inflation in the eurozone rose from 1.7% to an on-target 2%. This has allowed the European Central Bank (ECB) to cut interest rates eight times this year, from a peak of 4% in May last year to just 2% now, which compares to the Bank of England’s (BoE) five cuts to leave UK rates at 4%.

It’s a big reason why the yield on 10-year gilts (UK government bonds) has risen by 80bps since September, compared to a rise of 56bps in France (where the government is about to collapse for the third time), 50bps in Germany (which is embarking on the biggest borrowing spree since the second world war) and an 8bps drop in Italy (which at least used to have a reputation for fiscal incompetence).

So, why has UK inflation doubled when it’s merely ticked up in the eurozone?

Energy price caps, food inflation – and tax

Most of the difference relates to household energy prices. In the UK, household energy bills closely follow a price cap set by the energy regulator, Ofgem, every three months.

A big driver of changes from one period to the next is movements in wholesale energy costs, which are incorporated mechanically into the energy price cap calculation. It can therefore take time for shifts in the energy price outlook to feed through into bills and then the UK’s inflation figures.

While the approach to energy bills differs across euro-area countries, the key point of comparison with the UK is that, on the whole, prices tend to move only in response to sustained shifts in wholesale energy costs here. Pass-through is also faster.

It’s not just energy price inflation that has risen much faster in the UK then the EU. Core goods and food price inflation in the UK are also outpacing the EU’s rate of increase on these measures.

Movements in global commodity prices primarily drive inflation in these categories. So, the UK’s faster rise is probably down to firms passing on the higher employment costs that came into effect in April.

Similarly, for higher services inflation. In the UK, this has again largely been driven by bigger increases in taxes, duties and regulated prices. We estimate about three-quarters of the difference between UK and EU inflation is down to regulated prices like energy and education.

Is UK inflation policy-driven?

On a positive note, because almost all the difference in prices between the EU and UK is a direct result of policy choices, the gap should close if different policy choices are made in the future. Indeed, UK inflation should drop back below 3% next spring as long as there isn’t another round of duty hikes in the next Autumn Budget on 26 November.

Admittedly, UK wage growth is much stronger – at 4.7% vs 3.4% – than in the eurozone. This will need to come down for UK inflation to drop. But, given the recent weakness in the labour market, a slowing in UK pay growth seems inevitable.

The big risk here is that both elevated inflation and inflation expectations in the UK result in households and firms factoring higher inflation into their prices and wage-bargaining plans. For example, UK workers were more effective at protecting their purchasing power during the recent period of sky-high inflation than their euro-area counterparts. Real wages in Britain are about 5% higher compared with the end of 2019, but in the EU, they remain little changed. That could keep UK inflation elevated over the next year.

But, assuming the government doesn’t go for another round of stagflationary tax rises in the next Autumn Budget, UK inflation should start trending down after September and be back at around 2.5% by the middle of next year. This should be enough to allow the BoE to cut rates a little further next year, which, in turn, should help to bring down gilt yields, giving the government a little more breathing room for the 2026 budget.

For the full inflation forecast and for other key UK economic indicators, read our latest Quarterly Economic Outlook here.

UK economic recovery likely continued over summer

When the Office for National Statistics (ONS) releases the official GDP figures on Friday, we expect to see the UK economy will have grown 0.1% in July and against the headwind of the NHS resident doctors’ strike action.

The all-important services sector probably stagnated in July, as resident doctors’ strikes are likely to have dragged down healthcare output. Fortunately, NHS data suggests GP and A&E appointments held up well. Senior health officials have also stated that these strikes were less disruptive than usual, so we pencil in only a modest drop in output compared to previous bouts of industrial action.

The real economy probably fared slightly better as retail sales rose 0.6% in July and new car registrations mean we expect the retail sector to add around 5bps to growth. However, it wasn’t all good news for consumer-facing firms. Our RSM-CGA Hospitality Business Tracker points to official output falling 0.2% as hospitality firms struggled despite the flurry of sporting events in July.

On the production side of the economy, we think industrial output climbed 0.4% m/m. This will be driven by a 0.5% gain in manufacturing, where the output balance of the PMI jumped 2.5 points in July.

Notably, National Grid data suggests demand for electricity and gas rose strongly in July. Once we adjust the data for seasonal effects, the small utilities sector should add 3bps to GDP growth. That’s about the same as we expect the whole services sector to contribute.

The construction sector will probably contract by around 0.5% in July as the PMI slumped to its lowest level since the pandemic. Granted, the construction PMI has been far too downbeat of late. The weather was good in July, suggesting an upside risk, even if the huge drop in survey data is too big to ignore.

The upshot is that behind the headlines, July’s GDP data is likely to show that the economy continued to recover over the summer after April’s barrage of taxes and tariffs. Looking ahead, there’s a risk that sentiment around the Autumn Budget weighs on growth, but surveys continued to improve in August, suggesting that the economy is doing just fine.

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