CPI inflation: Peaked for now, but huge uncertainty over next year

The rise in inflation to 11.1% in October probably marks its peak. Given that inflation was considerably stronger than the 10.9% figure expected by the central bank, or the 10.7% median that economists had forecast, it raises the chances that the Bank of England will opt for a 0.5 percentage point (ppt) rise in interest rates in December. Inflation should decline rapidly from here, reaching 2% again by early 2024. But the potential removal of the energy price guarantee places a big question mark over the outlook for inflation next year. 

Core inflation continuing to rise

At 11.1%, inflation has returned to its 40-year high. The headline rate of CPI inflation shot up in October as electricity and natural gas prices jumped to the level of the government’s Energy Price Guarantee, and as prices continued to rise quickly for food and other goods. The rate of CPI inflation for electricity and natural gas prices stepped up to 88.9% in October, from 69.8% in September, resulting in a 0.9 ppt increase in its contribution to the headline rate. Food CPI inflation also increased to 16.4% - the highest rate since September 1977 - from 14.6%, as supermarkets continued to pass on the recent rapid increase in producer prices. The real bad news in this report, however, is that the pace of core price rises hasn’t eased yet, despite the recent softening in consumer demand.

Indeed, price pressures continued to build in services, with inflation now running at an annual rate of 6.3%, up from 6.1% previously and significantly above the 3.3% average for 2000-19.
The services inflation data will continue to have the MPC’s hawks on edge. Services constitute around 45% of the CPI basket. Services price rises tend to be stickier and it’s a category that’s closely linked to the evolution of the domestic economy, particularly the labour market, which is currently tight.

The good news, though, is that pipeline pressures eased for the fourth straight month in October. Inputs price inflation, measured by the Producer Price Index, fell to 19.2% in October from a prior reading of 20.8%.

What next? 

The good news is that inflation has probably peaked. The government’s energy price cap, in place for the next six months, will ensure there are no further rises in household utility bills over that period. Inflation is likely to steadily edge down over the winter, but larger-than-usual gains in food and services will mean annual CPI will still be around 9% in March.
After that the outlook becomes much murkier and depends on three key factors. 

First, inflation could be significantly higher next year, depending on how the energy price cap is reformed from April. Removing the cap completely could push inflation in April back to around 11% based on current market pricing, compared to if the cap remained. 

Second, the amount of austerity announced on Thursday will in large part determine how deep the recession is and how strong underlying inflation pressures are in 2023. 

Third, the main reason that the labour market is tight is because of a huge rise in the number of people on long-term sick leave. If these people do not return to the labour market, wage inflation may not fall as quickly as anticipated. This would make inflation stickier. 

The policy takeaway 

Our base case is for the MPC to raise rates by 50 basis points in December, after delivering a jumbo 75 basis point hike earlier this month. Price and wage pressures remain too high for a more substantial scale-back.

However, today’s inflation announcement, alongside yesterday’s data that showed pay growth is still soaring, increases the odds of another 75bps move. Overall, we’re still expecting interest rates to peak at 4.5% early next year.