The jump in inflation in October to 4.2%, its highest rate since 2011, was probably a bit higher than the Monetary Policy Committee envisioned a few weeks ago. Combined with yesterday’s robust labour market data, we think the possibility of a rate hike in December has increased.
Energy prices driving the inflation train
The rise in inflation from 3.1% in September to 4.2% in October was largely driven by electricity and gas inflation, which leapt from 2.8% in September to 22.9% in October. This added 0.7 percentage points to inflation in October, up from 0.1ppts in September. Fuel price inflation also rose further, contributing 0.6ppts.
Inflation in restaurants and hotels also rose strongly from 5.1% to 6.3%, as firms passed on the rise in VAT from 5% to 12.5%. The VAT change is a partial reversal of last year’s cut from 20%. A move back to that level is due at the start of April 2022. Another inflation increase was felt in the education sector, from 2.9% to 4.5%, which is likely to be a reflection of post-Brexit university tuition fee increases for EU students.
But the largest price pressures are being felt in those areas most affected by supply chain disruptions. Used car inflation is a whopping 22.8%, and goods inflation as a whole was 4.9% in October. Indeed, we estimate that about 45% of the doubling in inflation since July can be accounted for by energy, petrol and car inflation.
At the same time, services inflation was 3.2% and core inflation (which excludes energy, food, alcohol and tobacco) was 3.4%.
Inflation will keep climbing over the next few months as unfavourable base effects, higher oil prices and goods shortages continue to make themselves felt. But it will be April before it hits 5% – that’s when Ofgem, the energy regulator, increases its price cap again.
However, 5% will be the peak. Futures markets suggest that energy prices should start to come down next year and base effects fall out of the annual comparison. This means that inflation will fall just as quickly in the second half of 2022 as it has risen in the second half of 2021. Inflation could actually fall below 2% in early 2023 if energy prices continue to drop.
The policy takeaway
The stage now seems set for the MPC to hike interest rates in December. Inflation is almost double the committee’s target of 2.0%, and there’s no sign that the end of the furlough scheme in September adversely affected the labour market.
A second rate hike could then come as soon as February or May if the labour market continues to tighten over the winter. That said, rapidly falling inflation should mean that the MPC does not need to hike rates by as much as financial markets anticipate. Realistically, we think that by the end of the year interest rates will be closer to 0.5% than to the 1% the financial markets have priced in.