Inflation rose to an 11-month high in September, driven largely by higher motor fuel and heating oil prices. Looking ahead, we expect inflation to continue rising, reaching around 4.5% in the new year as utility bills reset higher and the indirect effects of higher energy prices feed through supply chains to consumer prices. For the Monetary Policy Committee (MPC), the combination of strong growth and sticky inflation means we think the Bank will have little choice but to hike rates in November.

Energy prices keep driving up inflation

Inflation rose from 3.1% to 3.5% in September. The increase was primarily driven by a further acceleration in motor fuel inflation, from 23.0% to 29.8%, and heating oil inflation, from 64.6% to 104.9%, as higher oil prices and wider crack spreads continued to feed through to retail prices. Together, those two components added 21bps to headline inflation.

Airfare inflation also rose sharply, adding a further 5bps to headline inflation. We expect airfares inflation to continue rising over the remainder of the year as higher jet fuel costs work their way through to ticket prices, particularly on more fuel-intensive long-haul routes.

Elsewhere, there was little evidence that higher energy costs are feeding through into a broader range of goods and services. Food and drink inflation held steady at 1.3%, while our broader measure of energy-intensive CPI increased only slightly, from 3.3% to 3.5%, largely reflecting the rise in airfares.

Overall, the rise in inflation is still almost entirely an energy story. While higher energy prices continue to push headline inflation higher, there remains limited evidence that inflation pressures have broadened materially across the wider economy.

Sticky inflation and strong growth point to rate hikes ahead

For the MPC, September's inflation came in around 50bps above its July forecast. Combined with stronger-than-expected growth and a further fall in unemployment, that makes a rate rise at next month's meeting increasingly likely.

Granted, the Committee will take some comfort from the fact that the overshoot has been driven by almost entirely by energy prices. However, the longer energy costs remain elevated, the greater the risk that those higher costs feed through into firm’s price-setting behaviour. Given stronger-than-expected growth and falling unemployment, we doubt the MPC will be willing to wait for much more evidence of those second-round effects before tightening policy.

Indeed, stronger-than-expected demand should also make it somewhat easier for firms to pass higher input costs on to consumers, increasing the risk that the inflation overshoot proves more persistent than the MPC currently expects. Indeed, we expect inflation to remain above 3% for most of next year as higher energy costs, elevated agricultural prices and emerging second-round effects feed through into consumer prices.

Even so, we doubt the MPC will need to hike rates aggressively. Despite the recent fall in unemployment, we still think some slack remains in the labour market, which should help keep wage growth relatively contained and reduce the risk of a sustained wage-price spiral.

Ultimately, inflation is likely to continue rising through the remainder of this year before peaking around 4.5% in the new year as utility bills reset higher. While the current inflation surge remains largely energy-driven, we expect the indirect effects of higher energy and agricultural prices to become increasingly visible over the coming months. With growth proving resilient and inflation likely to remain above target until 2028, we think the MPC will have little choice but to raise rates in November, followed by another hike next year.

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